From: Ron Kean (ronkean@juno.com)
Date: Wed Aug 25 1999 - 00:46:23 MDT
On Tue, 24 Aug 1999 14:19:33 -0700 (PDT) "Robert J. Bradbury"
<bradbury@www.aeiveos.com> writes:
> On Tue, 24 Aug 1999, Ron Kean wrote:
> > And if he just keeps the money in a vault, the bank which issued
> that money in effect gets an interest-free loan, and does the same
> thing, that is, invest the money.
> >
> Ok, so my $$$ are issued by the Federal Reserve. I don't think
> the FR is getting an "interest-free-loan" from me because they
> have a licence to print money. Your statement sounds interesting
> but I have a feeling one of us is missing something fundamental.
>
> Robert
It's only the Federal Reserve notes (cash) you hold, which are your
bearer receipts for what is effectively an interest-free loan from you to
the Fed (and indirectly to the Treasury, since the Fed turns over its net
profits to the Treasury). True, you don't get an invoice at the end of
the year for 3 cents interest on that dollar bill that you kept tucked in
a corner of your wallet all year long. Instead, the interest cost to you
is an 'opportunity cost', meaning that by holding cash you passed up the
opportunity to earn interest by lending out your cash. In exchange for
that you get the benefit of the ongoing potential to instantly convert
the money to something else, such as a cup of coffee.
To look at it another way, when the Fed issues cash, it does so against
the principal amount of interest-bearing Treasury securities it purchases
in the open market and holds. The Fed thus 'earns interest' from the
Treasury on the cash it issues. Then it turns that interest back to the
Treasury (minus operating expenses), so in effect the Treasury saves on
its net interest payments on the national debt, due to the fact that you
hold Federal Reserve notes. That savings on interest, by a government,
is sometimes called 'seignorage'.
Since most of the approx. $500 billion in cash which has been issued by
the Fed circulates outside the USA, foreigners are in effect giving the
US Treasury an interest-free loan of some $300 billion, which equates to
some $15 billion per year in seignorage.
As a practical matter, the US dollar is pure credit, issued under a
complex system of (mostly private) promises and guarantees. The dollar
is backed by debt (mostly private debt), in what might be called a
layered or interlocked system of private and governmental promises to
pay, and guarantees. Federal Reserve notes, which are only a small part
of the broader money stock, are backed by Treasury debt, but are not de
jure convertible into Treasury debt. Bank credit, which is a much larger
component of the money stock, is mostly backed by private debt, and
largely guaranteed by the FDIC (i.e., the federal government). The money
stock tends to be regulated by a free-market feedback mechanism whereby
creditors demand higher interest when inflation threatens, and debtors
hold out for lower interest loans when inflation wanes, though
conventional wisdom holds that the Fed jacks up rates when inflation
threatens, rather than the market. The market mechanism could arguably
be interdicted by the government, but that might be a deep subject.
Coins, such as quarters and dimes, are non-interest-bearing obligations
of the Treasury, and are informally redeemable by the public in Federal
Reserve notes. If you hold quarters and dimes, you are making an
interest-free loan to the government. If the Treasury were to issue too
many quarters and dimes, more than the public wanted to hold, the public
would deposit the excess in banks, the banks would shift the excess to
the Fed, and the Fed would use it to pay the Treasury. So the Treasury
can't force excess dimes and quarters into the market, because the excess
would quickly be dumped back on the Treasury, and the Treasury's account
with the Federal Reserve would be debited that amount.
Somewhat similar reasoning applies to Federal Reserve notes. Those notes
are 'purchased' from commercial banks by the public to the extent that
the public desires to hold the notes. The price the public pays for
holding the notes is the interest lost when they withdraw funds from
interest bearing accounts.
Ron Kean
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