Seigniorage Reform and Plain Money
[Paper given at the Forum for Stable Currencies, House of Lords, 20 June 2001. The paper has been revised in April 2013 in order to better connect to current lines of discourse]
Seigniorage means the income a government has from creating new money and spending it into circulation. The proposal of seigniorage reform, or plain money reform respectively, is focussed on how to create and issue new official currency. It is based on an advanced understanding of the nature and functions of money in modern information society.
Plain money refers to the official means of payment in a sovereign-currency system where all money – cash on hand as well as non-cash currency on account – is exclusively issued by a monetary state authority such as a national central bank and circulates as a homogenous money supply M among banks and nonbanks alike, i.e. a system no more split between interbank and public circulation, between central-bank money and bank money (sight deposits), and with no more M0 and M1, just M.
Problem background: Dysfunctions of Fractional Reserve Banking
Let me begin with giving a brief account of the problems that represent the background of the proposal of seigniorage reform, or plain money reform respectively:
1. Chronic finance problems of public agencies
2. Commercial creation of bank money out of control
3. Monetary and financial instabilities of various kinds.
1. Chronic finance problems of public agencies are well known:
a) unbalanced budgets at high level of government expenditure difficult to cut back
b) growing unwillingness among the electorate to pay high taxes, and as a result
c) governmental debt at very high levels, difficult to stop and to reduce, and impairing government’s ability to act.
2. Less known are the problems of out-of-control commercial creation of sight deposits by the banking sector. The large banks have usurped, as a matter of fact, the prerogative of creating money, i.e. the right of creating and issuing the stock of currency necessitated by the economy.
In today’s terms, the stock of money corresponds to the monetary aggregate called M1. M1 consists of all of the coin, banknotes and sight deposits in circulation. Coin and banknotes are the cash, whereas the sight deposits in current accounts are the non-cash. Banks do not mint coin (which is the traditional right of government) nor do they print banknotes any more (which has been made the exclusive right of central banks). However, banks create the sight deposits – also called demand deposits or overnight or checking deposits. They do it by granting loans, or by buying financial assets such as bonds or real estate, and keying the amount of money involved into the creditors' or sellers' current account. That is the amazingly 'weightless' way how central banks and banks alike create modern information-unit currency ex nihilo.
With the development of cashless payment practices, especially since the after-WWII decades, and the speeding-up of the velocity of cashless circulation by IT technology, cash now represents the minor part of M1, whereas the share of sight deposits has been growing ever faster.
In the UK 93% of the existing stock of money are now sight deposits. In the Euro area they account for 82%, in Japan for 75% and in the US for 60% (due to the use of dollar notes in many countries as a parallel currency, openly as well as in the submerged economy).
Keying sight deposits into an account is the cheapest and most profitable way of making money. They cause no procurement cost at all, and rather low transaction costs. Most importantly, sight deposits come with a special extra profit, because the money is lent to the customer at the normal lending-interest rate, whereas the bank itself does not really have to take up that money before they lend it. Instead of a normal margin profit of, say, 6% lending interest minus 3% borrowing interest resulting in 3% normal margin profit, the banks can avoid most of the borrowing interest. All other things equal, this can result in a margin profit close to 6% rather than 3%. The purchase of bonds and other securities acts in much the same way.
The present money and banking system is based on fractional reserves, i.e. it is a system of multiple bank-money creation on a small basis of central-bank money (reserves). Its core mechanism is ongoing clearing of cashless interbank payments (which includes customer payments) and settlement of the resulting balance in reserves on a daily or other basis. This, together with the low share of cash payments in relation to total payments, allows the banks to credit into existence high volumes of deposits on a relatively small basis of cash and reserves.
To what extent a bank actually needs to back up its deposits with cash and reserves depends on different national requirements and the size of the banks. By and large it can be said that in order to maintain their operations the banks need about 3–12 per cent in central-bank money on the 100 per cent of sight deposits in their balance sheet, of which about 1–1.5% cash in vault, 1–4% excess reserves for the final settlement of payments, and the rest idle minimum-reserve requirement.
It is rather difficult to come up with a satisfactory estimate of the banking extra profit from creating new money. Very certainly it is a huge privilege, hardly offset by competition in this rather oligopolistic business.
Moreover, since the private commercial banking sector rather than the central bank creates the public money supply, there are huge amounts of seigniorage foregone to the treasury. If one wants to get an idea of how much money the seigniorage foregone is, consider the annual increase in sight deposits plus interbank overnight deposits, because this is roughly the income a government would have if the issue department of the central bank were to create the non-cash money and leave it to the government for spending it into circulation – free of interest and redemption by the way.
In the UK the annual amount of seigniorage foregone is of a dimension of about £ 50 billion, in the Euro area of about € 240 billion. Any treasurer would certainly be happy to be confronted with the choice of opportunities these figures represent. Why then is this benign source of public income not being tapped?, particularly in view of the fact that in this case it is a real free lunch, burdening nobody, simply being the necessary annual addition to the stock of currency, newly created 'ex nihilo', or say 'ex conscientia' according to professional standards oriented to the growth potential of the economy at full capacity.
Since the introduction of coin about 2,700 years ago, the creation of currency has been the exclusive right of state authorities such as the treasury, or later on the parliament, or the central bank. Leaving that prerogative to the large commercial banks at the expense of the taxpayer and the customer is illegitimate. Official currency – circulating from hand to hand, from account to account respectively, being anonymous as a means of payment, not particularly belonging to somebody – is a public good the value of which should add to the common good, and should itself not be subject to money-making. The practice is unjust and dysfunctional also because of the large, and for the most part overshooting volumes involved.
3. Monetary and financial unsafety and instability of the existing fractional reserve system
Banks act procyclically. This is quite natural, everybody behaves like this, more or less so. When the economic situation or customers are thought to be good, banks tend to be risk-taking and relatively free-spending, and when the economic situation or customers are thought to be bad, banks tend to be more risk-averse and tight-fisted. Since the banks in actual fact now create all of the money in public circulation, the supply of money tends to fluctuate procyclically in exactly that way. In consequence, there is recurrent procyclical overshooting or shortage of the supply of money and capital. This is one of the main factors of financial instability, and as such a main cause of periods of excessive boom and bust, in the real economy as much as on financial markets (asset inflation resulting in over-indebtedness and banking crises or general financial crises).
Today’s fractional reserve system, with its mixed money base and its mixed non-cash circulatory system, is actually a mixed blessing. Seen in historical perspective from a legal and monetary point of view, it represents a muddled transitional stage in-between the traditional metal-money ages where it comes from, and the future of purely information-unit fiat currency where it is heading for. At its present stage, the reserve system has become non-transparent and difficult to understand (even most bankers don't). The quantity of money is impossible to control, and the system is prone to instability and crisis. Deposits in banks are as unsafe as ever. In an individual bank failure, state guarantees and deposit insurance may help. In a general banking crisis, however, the ability of central banks to act as lender of last resort is bound to reach its limits.
The Huber/Robertson Reform Proposal
Having presented the above list of problems we certainly don't claim that seigniorage reform, or plain sovereign money reform, would be a cure-all to any monetary and financial difficulty. Nevertheless, monetary reform as we propose it would definitely solve the problems of monetary safety, full and pro-active control of the quantity of money, legitimacy of the creation of money, and it can considerably contribute to solving problems of government finance as well as wider problems of financial and economic stability. This would not result in a confusion of monetary and fiscal responsibilities. The public purse would simply benefit from monetary policies taking place anyway.
Seigniorage reform, or plain sovereign money reform, consists of two elements which can be seen as two sides of the same coin. The one side of it is fully restoring the monetary prerogative; the other side is phasing out bank money, i.e. the use of sight deposits, i.e. bank liabilities or bank debt, as a means of payment).
The monetary prerogative comprises three rights under public law: to determine the national currency unit of account, to issue the money (the means of payment) denominated in that currency, and to take in the seigniorage which accrues from creating new money. The monetary prerogative is a matter of constitutional importance, of the same weightiness as the prerogatives of legislation, jurisdiction, taxation and use of force.
The issue department of a nation's, or community of nation's central bank would decide regularly how much money is needed, pursuing discretionary rather than rule-based policies. Central banks should be in a position of institutional independence. Under normal conditions, neither parliament nor government should have a right to force decisions out of it. Technically, the issue department would prepare its decisions, quite similar to how it is done today, on the basis of
a) monitoring real-economic as well as financial-economic growth, i.e. creation of money oriented towards the growth potential of nominal and real GDP
b) interest rates (higher/lower rates indicating stronger monetary demand/supply) as well as
c) taking into account the weekly and fortnightly statistical reports of the banks and the structure and volume of their borrowing and lending transactions.
The issue department would transfer the newly created money to the treasury. The government would in turn decide how to use the 'free lunch' of seigniorage – whether to spend it, say, on education, or income allowances, or to pay back governmental debt, or to reduce taxes (e.g. by granting annual seigniorage tax credits), or any combination of such possibilities.
The other side of monetary reform is to make sure that banks will be able to continue with basically everything they do now, except creating sight deposits. Creation of sight deposits by the banking system must be ruled out.
This twofold goal of seigniorage reform – restoring the public prerogative of creating money, and putting an end to the creation of sight deposits by the banking system – can be achieved by two legal measures combined with a technical measure, all of which are simple, and easy to implement.
First, sigh deposits need to be transformed from the mere money claims/liabilities they are at present into positively existing units of non-cash currency, i.e. plain money. The corresponding legal measure is this: In the banking laws, the article on the issue of banknotes needs to be amended as to include non-cash money on account and mobile storage media in addition to banknotes and also coin. In this way, sight deposits would obtain the status of legal tender. The law would thus catch up on the common practice that sight deposits in current accounts are already used as if they were official money – which they aren’t yet, as long as they haven’t been declared to be positively existing units of plain money.
The second legal measure is to declare the current accounts in a bank to be money accounts exclusively ascribed to the customer. In the same way as we have coins in the pocket, and banknotes in our wallet, customers will have non-cash plain money in their money account. This isn’t the case today either, even if it looks like this. Not only are today’s sight deposits mere money claims/liabilities instead of being information-unit currency, but also the 'containers' of sight deposits, the current accounts, are part of the banks' balance sheet, i.e. they belong to the bank, as they belong to the customer at the same time. If the settlement of a customer's money order involves payment of reserves, than these reserves don't flow from customer to customer; instead, they flow from the operational account of the bank in charge to the operational account of the receiving bank.
That's why the legal act of declaring current accounts to be money
accounts needs to be combined with a technical measure of accountancy: the current accounts will be taken off the banks' balance sheet, so that they exist separately, as off-the-balance items seen from the banks' side, like e.g. stocks and security custody accounts a bank manages for its customers. The booking entries in the future money accounts just regard the customer, no longer the bank. Money accounts and cashless payment orders can certainly be managed by the banks, as a service to the customer. But the money account of the customer will no longer be of a bank’s business, i.e. no longer be part of the banks‘ balance sheet. [1]
When a bank wants to grant a loan, it will have to make sure to have borrowed the money it is going to lend. If the bank borrows from its own customers, this will no longer be represented by replacing a current-account overnight liability with an inactivated, longer-term liability on another account. Instead, it will include an actual transfer of plain money from the customer's money account to the bank’s operational account with the central bank. From there the money will then be paid out to the money account of the person or institution who takes a loan from the bank or sells securities or real estate to the bank.
Existing clearing and settlement systems can still be used, in much the same way as today. Clearance of payments from customer to customer, from customer to bank, and from bank to customer may need some adjustment of how these are accounted for.
Advantages
The advantages of seigniorage reform are manifold. We tried hard to find some possible disadvantage, a search in which we didn't succeed so far. A possible coalition in favour of seigniorage reform can include almost everybody because everybody can expect to gain from it – except the banks who would lose the usurped privilege of creating themselves the money on which they operate.
Seigniorage reform represents an obvious next step in the evolution of the monetary system. It is not about overthrowing what exists, but just a little, though important restructuring of long-established institutions and practices. The proposal actually allows to keep almost everything in the existing system as it is, if this were the political will.
Further advantages include the obvious benefits to the government budget. This in turn can leave to the taxpayer more of their income, thus contributing to a higher stock of national capital, particularly in the hands of private households and small and medium-sized businesses.
The biggest part of the money supply is issued long-term, as a matter of fact 'forever' so-to-say. This part ought to be issued as genuine seigniorage by spending it into circulation through public expenditure. As far as the stock of currency will be issued in this way, it will be debt-free, i.e. the money base of the economy is neither burdened by interest nor by pay-back. This would result in a lower overall level of interest, with an accordingly higher overall level of investment and employment.
If need be, a small part of the new money can also be lent to the banks on a short-term basis. This creates interest-borne seigniorage, and should be seen as an exception to the rule.
Plain money on account would completely be safe.
The stock of currency in circulation will be stable under any circumstance, and its increase will also be stable or continuous, transmitting itself into stabilising effects on the real economy.
The quantity of the stock of currency would be fully under the control of the issuing monetary authority (the issue department of the central bank, as we suggest). Insofar as the quantity of money is a particularly important contributory factor to inflation and asset inflation, that factor will be fully under control, in complete contrast to the present muddled system in which the central banks have lost control over the quantity of money, and the commercial banks key in as much deposits as they think creditworthy or profitable, with considerable recurrent effects of accelerating consumer-price inflation and asset inflation (financial investment bubbles of an increasingly speculative character), in other cases also maybe aggravating deflation (as recently happened in Japan).
Plain Sovereign Money
The monetary system outline above can be called a system of plain money, or plain sovereign money. In today’s fractional reserve system there is mixed money, from mixed sources, with a mixed legal status of validity, and a split non-cash circulation, the one as interbank circulation via operational accounts (central-bank reserves), the other public circulation via current accounts (banks' sight deposits). Cash has by now become a mere remnant of the metal age of money, an exchange form of non-cash. Technically this is a non-transparent system, in fact impossible to control, hence unsafe and unstable, and also unfair, to put it mildly, with regard to extra-profitable banking privileges.
Plain money, by contrast, is fully valid legal tender (lawful money), sovereign money on account as much as on hand. Plain money takes full advantage of the fact that modern money is fiat money that can freely be created and has no inherent physical value. The units of today's currencies just represent information about economic value. They convey an amount of purchasing power equivalent to that value. The value comes from the productivity and competitiveness of the real economy, whereas the amount of money in circulation (the means of payment) is created and controlled 'ex scientia'. In the case of plain money, the currency comes debt-free from a single, democratically authorised source, thus making sure that the value of it is yielded for the common good. And all of the currency is part of one integrated money supply M (instead of the existing split system with M0 and M1). Plain money constitutes a simple and robust system, easy to understand, to handle, and to keep control of.
Impact on the Banking Business
Seigniorage reform is far from being a threat to banking. Also the profitability of banking is not at stake, simply that part of banking profits which represent the supernormal special profit from crediting deposits into current accounts. For all of the rest, the banking institutions and the financial markets can stay the same. Their everyday practices and procedures might continue as if nothing had happened. Nothing will be expropriated, no one's monetary possessions, claims and liabilities, including the banks', will be altered in volume or value.
Seigniorage reform is about restoring and keeping a fully nationalised stock of money. It is not, however, about nationalisation of banking. Under conditions of plain money, banking can be as free a business as set by law and regulation. Plain money is not about additional regulation and bureaucracy, rather less. Considerable parts of banking regulation (actually not really effective) have come about as a reaction to the problems of fractional reserve banking.
As far as customers will keep more of their income and will be able to accumulate a higher level of own capital, they will certainly become better banking customers than they are today. In this way, the loss of illegitimate banking privileges could to a certain extent be compensated for by a higher volume of business to generally better-off customers.
Competition among banks and the efficiency of banking would gain from seigniorage reform, because it puts an end to the oligopolistic
advantage the large banks do have in the present reserve system. The ability of the smaller banks to create sight deposits is more restricted because, having less customers, a smaller geographic radius, and less turnover in payments in and out, the smaller banks need much more reserves in order to carry out their activities than the large banks of nation-wide and international standing with many millions of customers and many billions in turnover, which makes them nearly independent from central bank reserves, all the more as central banks always accommodate banks' demand for reserves. This may happen at higher or lower interest, which slightly changes the profit margin of banks, hardly however the actual, highly price-inelastic demand for reserves.
A transition from bank money to plain sovereign money would thus contribute to a fairer competition between smaller banks and large banks. And that's why seigniorage reform, if properly communicated, may even find the tacit support of the small and medium-sized banks and other businesses in the financial services sector.
Furthermore, the structure of what is nowadays considered to be a bank will become clearer. Today, banks fulfill at least three different functions. These do not need to exist under one roof (universal banks). Different banking functions can also be carried out in separate businesses, and this is partly already the case:
1. Banks are service banks. They manage customer current accounts and cashless payments, and provide cash and foreign exchange.
2. Banks are commercial banks, active in the credit business properly speaking, thought of as a 'savings and loan' institution, or 'deposit' bank, taking up money on the one side and making out loans for financing various purposes on the other.
3. Banks are engaged in investment banking; partly by doing proprietary trading on and for financial markets, partly as full-fledged investment banks. Investment banking covers quite a number of rather different financial activities, including underwriting of initial public offerings of bonds, stocks and other securities, market making for the trade in derivatives and underlyings, the financial handling of mergers and acquisitions, or asset management for customers.
A transition from fractional reserve banking to plain sovereign money would have two important consequences for this three-tier structure. Firstly, the function of service banking would in actual fact be separated from commercial and investment banking. Secondly, commercial banking would become what people (and most experts) think it to be, though this is actually not the case: banks that lend out their own and other people's money, i.e. deposit and loan banks indeed.
Obviously there is a connection here to the question of universal vs separate banking. So it should be pointed out that separate banking, in particular setting investment banking apart from commercial banking, is not an inherent part of monetary reform. Formal separation of commercial from investment banking is less important than one used to assume. More important is whether or not commercial banking is allowed to provide credit leverage for investment banking. The really important separation is the one between service banking and the rest. It was only forerunners of seigniorage reform and plain money, in particular advocates of 100%-reserve banking such as I. Fisher, H. Simons, M. Friedman, or M. Allais, who had understood this (notwithstanding that 100%-reserve banking is a suboptimal approach in many other respects. Cf. > 100% Reserve (Chicago plan) and Plain Sovereign Money on this website).
It remains to be seen how far the three functions of (1) money services, (2) credit banking and (3) investment banking will continue to be carried out under one roof or whether functional differentiation which takes place anyway, in combination with some new regulation on 'living wills' and liquidability of insolvent banks, will step by step lead to separate businesses.
Seen from the standpoint of seigniorage reform and plain money, one thing is definitely clear: Banks must stop to create sight deposits which results in a functional separation of money services from credit and investment banking. Given this functional separation, the service of managing money accounts and cashless payments can furthermore be done by traditional banks, but can also perfectly be done by specialised separate businesses. The latter might even be more cost-efficient than what we have today where the banks are actually not that interested in the service of account management and handling cash and foreign exchange – though it gives them indirectly the illegitimate privilege of making money out of nothing, thus acquiring for private profit what has always been a public good.
- - - - - - - -
[1] Banks‘ current account liabilities will nevertheless continue to exist for a while – as liabilities to the central bank (which should have created these means of payment in the first place). As customers will redeem their loans to the banks, the banks will pass on that money to the central bank, so that the remaining current account liabilities of the banks to the central bank will be extinguished on both sides of the central bank-bank-relationship and be phased out step by step. The central bank will replace the 'old' money in reflux with newly issued plain sovereign money.