Reforming Seigniorage the Key to a Sustainable Economy

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Eric Zencey is a novelist, essayist, and Visiting Associate Professor of Historical and Political Studies for Empire State College in Europe and New York.  His writing in environmental history and political theory has been supported by grants from the Rockefeller, Guggenheim, and Bogliasco Foundations.  This essay is from the forthcoming The Other Road to Serfdom:  Essays in Sustainable Democracy (University Press of New England, Fall 2011).

Chances are that unless you’re a total financial wonk, you’ve never heard the term “seigniorage.” But you should, because doing the right thing with it could help solve several major, interrelated problems.

As a concept, seigniorage is as old as money. It’s the difference between the face value money and its cost of production; it’s the profit that comes from creating money. When money was coined in valuable metals, seigniorage wasn’t very significant; a shekelhad to contain something like a shekel’s worth of silver, or it wouldn’t be accepted as a token of exchange. The advent of paper money and the more recent development of fiat money—money backed not by metal but by the faith and credit of a government—led to a dramatic increase in seigniorage. If it costs one cent to print a hundred dollar bill, the seigniorage on that bill is ninety-nine dollars and ninety-nine cents.

By long tradition, and by general consensus among anyone who ever thought much about it, seigniorage belongs to the sovereign power that issues money. In our system, that’s us: we, the people. But in the largest subsidy program ever instituted by any government anywhere, most of our seigniorage is given away free to the institutions that create most of our money supply: private banks.

To most of us the idea that banks create money comes as a surprise. Here’s how it happens: when you deposit $100 into your checking account, the bank is required to keep only a fraction of it on deposit against the chance you’ll show up and ask for cash. The rest it lends out as quickly as possible. With a reserve requirement of 10%, your bank can lend out $90 of your $100 deposit, which it does by simply crediting the borrower’s account—an act that costs almost nothing. And 90% of that new deposit can be lent out as well, which becomes a fresh $81 dollar deposit in the system. And so on. Eventually, the introduction of $100 into a system with a 10% reserve requirement leads to a $1000 increase in the money supply.

This system of fractional reserve banking evolved organically from the goldsmith’s practice of issuing notes for sums of coins held on deposit—and from some enterprising goldsmith’s recognition that the notes themselves, and not the coins, were being used in commercial transactions. Since few people actually brought the notes in to redeem them for gold held on deposit, it was possible to lend out the gold and collect interest on the loans. The loans could be issued as notes, with the gold remaining unmoved within the goldsmith’s safe. A single bag of gold coins could do double, triple, quadruple duty: two, three, or four people could hold certificates claiming it—as long as they didn’t actually claim it.

Clearly, the practice of leveraging loans against deposits in this way made goldsmith shops (and, later, banks) vulnerable to a cascading collapse of confidence—a “run”--when holders of certificates of deposit show up and demand the return of what they’ve deposited. This is exactly what happened during the Depression, sparking a round of bank failures and deepening the economic downturn.

In the wake of that experience, the practice of fractional reserve banking might have been forbidden, and the creation of money be reserved to the sovereign power of government. Instead, fractional reserve banking was formalized, and the perceived problem—that cascading collapse of confidence—was addressed by the creation of the Federal Deposit Insurance Corporation, which assures customers that the government will make good their deposits (up to the generous limit of $250,000 per account) if the banks fail. Banks were given free rein to go on creating money, and to collect seigniorage in the form of interest on the loans they make with the money they create.

How much is that seigniorage worth? The money supply on which the U.S. economy operates is $7.7 trillion. Of that, scarcely a tenth--only $746 billion--is actual currency issued by the Treasury, the seigniorage on which goes into the public coffers. The rest, $7 trillion, is bank balances in various forms. And since the cost of entering pixels into databases is negligible, the seigniorage is almost equal to the supply of money created this way. Seven trillion dollars is more than the federal government has spent on two world wars, Korea, Vietnam, Iraq, the moon mission, and Social Security combined.

Capturing seigniorage for the public treasury presents no technical challenge. To make money creation the exclusive prerogative of the sovereign, the money-creation activity of banks could be curtailed by a 100% reserve requirement on demand deposits. The change could be phased in gradually, as Herman Daly and other ecological economists have advocated. Banks could earn their income not from seigniorage but by charging for such legitimate and useful services as safekeeping, accounting, check clearing, and mediating loans between savers and borrowers. As the new reserve requirement is phased in, the Treasury could spend money into existence at an appropriate rate, replacing exactly the quantity of money that banks are no longer creating. The immediate macroeconomic effect would be minimal; the net result would be a shift in the way money is created, and an end to a huge public subsidy to the banking system.

One macroeconomic effect would be eventually significant: loans could only be made out of savings, not from the creation of money. This means that someone, somewhere in the system, would have to refrain from consumption today in order to increase consumption later. The only argument that can be made against this essentially boils down to “we’d have to change how we do things.” One consequence of doing this is that we would no longer pay for our consumption today by passing the expense to our children and grandchildren.

Bankers, of course, will be against this change, and will do everything in their considerable power to prevent it. Creating money, it turns out, is a very lucrative business. But there are positive effects that make this policy change very attractive.

One benefit would be a dramatic dampening of our economy’s boom-and-bust cycles. As chemist-turned-economist Frederick Soddy pointed out in the 1920s, the creation of money by banks is also the creation of debt, and boom-and-bust cycles are one inevitable result of letting debt grow too rapidly. Soddy’s logic: debt is a claim on the future production of wealth. When the creation of debt exceeds the capacity of the economy to create the real wealth that is needed to pay it off, eventually a trigger event will set off a cascading crisis of debt repudiation—a run on the bank, writ large. Inflation, bankruptcies, foreclosures, stock market crashes, bond failures—these are forms of debt repudiation, and (inflation excepted) they tend to come in a spasm, a crisis, a collapse.

The Great Recession we find ourselves in today follows this pattern. A run-up in the price of gasoline to $4 a gallon reduced the disposable income of Americans, including many who had been encouraged to take on more mortgage than they could afford. That they were encouraged to do this was one result of “demand-pull” for risky mortgages. With banks like Goldman Sachs actively assembling portfolios of bad mortgages so that hedge fund managers could bet against them, loan officers nationwide stepped up to supply the demand. They responded to an increased call for risky mortgages by issuing more risky mortgages. When some mortgagors defaulted, housing prices declined, and many homeowners found themselves “underwater”—owing more on their houses than the market said they were worth. This led to more defaults, which led to more defaults, which led to more defaults.

The version of the crisis that began in 2008 had its origin in mortgage loans. But the same dynamic lies underneath all crises of debt repudiation—the Savings and Loan crisis, the Enron affair, the crisis of Asian debt refinancing, the stock market crash of 1987. They all trace to the process of letting claims on wealth grow faster than wealth can grow, and the driver of that is the process of money-and-debt creation through fractional reserve banking.

Money that is created and spent into existence by the government does not create this equal-and-opposite burden of debt. At bottom, fractional reserve banking is a routinized, publicly funded machine for inflating speculative bubbles, based on the bizarre supposition that $100 of wealth can be made to support $1000 worth of claims upon it. It takes a lot of economic growth to produce $1000 worth of wealth in the future for every $100 worth that exists today.

One reason that economic growth can’t match the rate of debt creation is the ongoing decline in the energy-return-on-energy-invested, or EROI, of oil, our economy’s primary fuel. In 1920, one barrel of oil invested in drilling and production yielded 100 barrels of usable product—an astounding 10,000% return, large enough to disguise quite a few structural flaws in our system. But by the close of the twentieth century the EROI of oil had fallen, worldwide, to 20:1 (For newly discovered oil, it is even lower: 5:1, by some estimates). This decline is both an underappreciated root of our current economic downturn and a warning that we have to change our institutions--and the thinking that underlies them.

The decline in EROI is a portent that austerity in public spending is not a temporary passage from which recovery is possible, but something like the permanent condition of governance in the post-petroleum era. Oil’s 10,000% rate of return was magic. It created fortunes (think Rockefeller and Getty), fuelled philanthropy, and ultimately paid for a lot of public works: schools and bridges and roads, Medicare and Social Security, moon missions and foreign wars. Today, governments at every level are struggling to sustain their revenues and provide essential services, even as their tax bases decline as a result of the recession. Meanwhile, the disposable incomes of many Americans have tumbled, and Tea Partiers shout that they’ve been “Taxed Enough Already”—taxes being one sizable household expense which citizens of a democracy feel they ought to have some say over.

There’s room for hope in the fact that the best renewable energy technologies come close to matching today’s world-wide average EROI of oil. But no energy technology will ever again offer the heady returns of the early days of oil. As we enter a crowded, ecologically straitened, post-petroleum era, the need for sound, far-sighted public expenditure on infrastructure, including renewable energy infrastructure, has never been greater, while the resources to pay for it have never been more constrained. Capturing seigniorage is one way out of this conundrum, and phasing out fractional reserve banking is the best way to do that.

Think back to that unnamed goldsmith who first had the idea of making loans against money that belonged to someone else. Through one conceptual lens, the man was an innovator, a banking genius: the gold was just lying there, not being used, so why not issue additional notes against it? Through another lens, though, the man committed fraud: he treated as his own something that was not his to lend. The fact that we’ve had centuries of routine acceptance of that basic fraud doesn’t change the essential character of the act. And aside from the moral considerations that call into question the foundation of fractional reserve banking, there are also large practical reasons for changing our practice. The pyramiding of debt through fractional reserve banking is one strong driver of heedless economic growth, “growth for growth’s sake,” which has expanded our economy’s ecological footprint beyond sustainable limits. Returning seigniorage to its rightful owner is a strong step toward ecological, and civic, sanity.

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