Sometime in 2000 I had a discussion with 2 friends on the Asian Financial Crisis and the strength of the US market then (Greenspan's 'irrational exuberance' was still very much alive then). There were people predicting that the Dow would reach 20,000 where the average PE would be 40. That seemed odd to me as PEs in Asian markets were reportedly less than 10 - for me the obvious thing was for money to flow into Asia but that was not happening.
But my 2 friends assuredly explained my observation by saying that the Asian Crisis was caused by corruption and bad management of Asian companies, and people were willing to pay a 'premium' for American stocks because they had better management practices. One said that American companies for example know when to cut loses if investment returns were bad but Asian management do not. But I said that I didn't believe such 'west is better than east' stuff (to me people are the same everywhere).
This was despite the fact that a lot of people were already warning about the 'unreal' economics behind the internet boom. Although I could not explain it, I said that I suspect the strength of the US economy could also have something to do with the US dollar. This is on top of the benefits accrued to it by whacking Iraq in the 1990 Gulf War and getting $90 billion payments from the stupid Arabs, Japan and Europe (for expending all of America's old armaments on Iraq! In accounting lingo, it was deriving income from fully depreciated assets).
Some months later I received the below mail from one of them who happen to be an economist.
In subsequent discussions with this friend, I suggested that the 'USD advantage' may also explain why the Europeans had created the Euro (I was still quite 'blur' about this topic then), and why the US wants to whack Iraq (there were already 'speculations' that it was partly because Saddam Hussein was asking for oil payments in Euros).
But this friend told me that he does not think the above 'advantages' are real as the market is 'free'.
Hi,
I remember your question about the advantages the US enjoys because of the special status of the US dollar as a global reserve currency. One such benefit is called seignorage - though it is a benefit accruing not exclusively to the US government. The Americans simply could benefit from it more than any one else on earth.
Rgds,
Yin Sze
Seignorage
Seignorage is the difference between the value of money and the cost of its production. In the classic example, the sovereign holds the exclusive right to create money and thus profits from minting coins that cost him less to produce than their face value. He himself spends the coins into circulation. How does this differ from seignorage in our fiat money system?
Seignorage from Federal Reserve Notes
The U.S. government has the exclusive right to issue Federal Reserve notes. As of November 2000 a total of $550 billion in notes were outstanding with an annual replacement cost of about $450 million. The present value of those costs, continued indefinitely and discounted at 5%, is about $9 billion. The seignorage resulting from the monopoly on note issue is therefore worth about $550 billion - $9 billion = $541 billion. Is this a true windfall for the U.S. government? In order to understand the answer to this question, we need to look first at the details.
Acquiring the Notes
The Fed buys the notes from the Bureau of Engraving and Printing at the Treasury at a cost of about 4 cents each. It sells them at face value to banks on demand. The Fed is required by law to pledge collateral at least equal to the amount of currency that it issues. Most of that collateral is in the form of Treasury securities owned by the Fed.
The term collateral here is only symbolic. Treasury bonds do not represent a claim on the real assets of the government. They are merely interest-bearing IOUs that are guaranteed to be repaid at maturity in legal tender, more Federal Reserve notes.
Effect of Cash Withdrawals
Consider what happens when a bank buys Federal Reserve notes from the Fed. Its deposit at the Fed is debited accordingly. However the Fed's reduced liability to the bank is balanced by an equal increase in its note obligations. The sale of notes is a reversible transaction. Banks can sell notes back to the Fed and regain deposits at any time. The Fed simply swaps two liabilities as it buys and sells notes to banks.
Now consider what happens when the public increases its cash holdings by withdrawals from banks. Since a bank's vault cash is a part of its reserves, net withdrawals of cash reduce the aggregate banking system reserves. In order to support the Fed funds rate as set by the FOMC, the Fed must replenish those reserves. It does so by buying Treasury securities in the open market, thereby restoring deposits to the banking system.
In effect, the public trades some of its Treasury bonds to the Fed for the additional cash. The public foregoes interest earnings on those bonds in proportion to the cash it holds. Those bonds become assets of the Fed, and remain as obligations of the Treasury. The Treasury must pay the Fed to redeem the bonds when they mature.
Maturing Treasury Bonds
How does the Treasury cover the redemption of maturing bonds? If it has a budget surplus it retires them with the available surplus. Otherwise it rolls them over, i.e. sells new issues to pay for the old.
If the Fed owns the maturing bonds, there are two options. The Fed can simply debit the Treasury's account at the Fed in exchange for the bond. In that case the Treasury must replenish its funds by selling new bond issues to the public. The purchase of new T-bonds would result in a loss of banking system reserves if the Fed did not replenish the reserves by buying more bonds from the public. Thus the Fed must replace the bonds in its portfolio as fast as they mature simply to maintain its control over short term interest rates.
The second option is for the Fed to roll over its maturing bonds directly with the Treasury. The new bonds are paid for out of the proceeds of the maturing bonds. Whether the public or the Fed owns the maturing bonds, the total supply of T-bonds outstanding remains unaffected by the redemptions.
Reducing the Treasury's Interest Cost
When the public increases its cash holdings, the Fed's portfolio of T-bonds increases while the public's ownership of T-bonds decreases. This reduces the interest cost on government debt because the Fed rebates most of the interest earned from its T-bond portfolio to the Treasury. Other things equal, the more cash the public holds, the lower is the cost of servicing the national debt.
Seignorage vs Deficit Spending
In a sense the concept of seignorage in a fiat money system is incongruous. The government has unlimited spending power and thus has no need for seignorage. Normally it covers any shortage in tax revenues with the sale of bonds, paying whatever interest rate is demanded by the buyers. Under extreme conditions as in wartime, the Fed could be required to buy them. In effect deficit spending would then be funded from newly created money rather than recycled money. To avoid the obvious inflationary implications, special controls would be needed to restrict the amount of credit creation by the banking system.
A Case of Real Seignorage
Real seignorage exists for those Federal Reserve notes that have migrated overseas, an estimated 60% of the total issued, or about $300 billion. At a cost of a few cents each, those notes bought foreign goods and other assets at face value for the U.S. As long as the notes remain overseas, those purchases are virtually cost-free. An interesting question then is: who is the actual beneficiary of that seignorage?
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