Honest Money P
eople the world over recognize to U.S. citizens: the “taxes” paid by
the U.S. dollar. Above George foreigners holding dollars reduces
Washington’s portrait, the words the amount of income taxes that
“Federal Reserve Note” carry a must be collected from U.S. citizens.
Is the Best promise in which many people trust.
It’s the promise of honest money
If U.S. taxpayers benefit from
seignorage, why doesn’t the Federal
Policy that holds its value.
Some $375 billion today circu-
lates in the United States and abroad.
Reserve make the dividend even
larger by printing more currency
and raising more seignorage from
Not only is the U.S. dollar held foreigners? The answer is because
more widely worldwide than any people worldwide seek honest
other currency, estimates indicate money, an attribute the U.S. dollar
that more American currency is held would quickly lose if the Fed aban-
abroad than in the United States. doned its pursuit of low inflation.
What U.S. citizen touring abroad By limiting the amount of currency
hasn’t seen U.S. currency used in in circulation, the Fed can provide
exchange for goods and services? a stable-valued currency and keep
American money circulates in the dollar competitive against the
Mexico, Israel, Russia, virtually numerous alternative currencies
every foreign country. Today, the available to the public, such as the
U.S. dollar is the world’s currency German mark, the Japanese yen and
of choice, and it has been for the Swiss franc. Inflationary policies
several decades. would undermine the dollar’s value
This popularity does not mean, and send dollar-holders to a more
however, that the dollar faces no honest currency.
competition from other currencies, When it comes to raising revenue,
or that an infinite supply of U.S. honesty is the best monetary policy.
“When it comes to raising currency should be made available The best monetary policy imposes
to the world. In fact, the dollar’s its own internal discipline, limiting
revenue, honesty is the best widespread use in foreign countries the amount of currency printed.
monetary policy. The best raises several questions. Do foreign From time to time, people call for
holdings of dollars help or hurt a form of external discipline — a
monetary policy imposes its Americans? And what, if anything, return to the gold standard. Ameri-
should be done to safeguard the cans taxpayers, however, can benefit
own internal discipline, dollar’s value? Understanding the more from a fiat money standard
limiting the amount of answers to these questions lies in in which the value of currency is
understanding how the government stable over time than from a return
currency printed.” finances its spending and, in par- to the gold standard.
ticular, the role of seignorage.
Seignorage is the volume of Fiat Money or Gold?
goods and services that govern-
ments buy with the fiat money they Until August 1971, the United
print. Fiat money is paper currency States maintained the gold standard,
that’s not backed by gold or other a monetary policy that backed
tangible assets. In effect, seignorage every bill in circulation with gold.
is an alternative to income taxation Under the gold standard, the num-
for financing government spending. ber of dollars circulating was deter-
The United States’ seignorage oppor- mined solely by the quantity of gold
tunity has been somewhat unique. held by the Fed. Consequently, a
Because 50 percent or more of all gold strike in Alaska, California or
U.S. dollars are held abroad, for- anywhere else that added to the Fed’s
eigners, as well as U.S. citizens, gold reserves meant more money
bear the burden of U.S. seignorage. could be circulated. Conversely, a
So, seignorage not only substitutes loss of gold reserves meant the Fed
for income taxation, it also repre- had to take an equal amount of
sents a means of “taxing” foreigners. currency out of circulation.
Seignorage amounts to a small gift An attractive feature of the gold
Base Money and the Consumer Price Index
Billions of dollars Index
CPI (right scale)
Base money (left scale)
“Seignorage is an alternative
to income taxes or greater
20 public indebtedness, not a
0 100 free lunch. Overreliance
’75 ’76 ’77 ’78 ’79 ’80 ’81 ’82 ’83 ’84 ’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93
on seignorage violates the
standard was that it imposed an chases. Government can pay for honest money principle and
external restraint on the Fed. With- goods and services by taxing,
out additional gold, the Fed could borrowing, or printing currency. amounts to an attempt to get
not add money to the economy. Under today’s fiat money standard, something for nothing.”
Money was backed by gold reserves, budget revenue is raised through
so sustained episodes of inflation seignorage when the Federal Re-
could not occur. If paper money serve buys U.S. Treasury securities
was devalued by inflation, people in the form of T-bonds or T-bills.
traded currency for gold, which Essentially, the Fed trades currency
reduced the money supply and put for Treasury debt, indirectly pay-
the clamps on inflation. Hence, the ing for the Treasury’s purchases.
value of money was dictated by the (If the Treasury paid off its debt,
official dollar price of gold. the fiat money would effectively
Today, the Fed does not back be backed by the Treasury’s taxing
each bill with gold. Instead, the authority. However, historically the
value of fiat money is maintained Fed has written off the Treasury’s
through the Fed’s restraint in main- obligations.1 )
taining honest monetary policy. Seignorage is an alternative to
The reason a fiat money standard income taxes or greater public in-
can make people better off than debtedness, not a free lunch. Over-
they would be under a gold stan- reliance on seignorage violates the
dard is simple. Under the gold stan- honest money principle and amounts
dard, huge quantities of precious to an attempt to get something for
metal had to sit in Fed warehouses nothing. But the economics of supply
to back the currency. A fiat standard and demand prevent that from
lets people benefit from seignorage happening: if supply increases, the
and releases the gold for people to price falls. For money, the price is
enjoy, benefits that accrue as long its value —how many goods and
as the Fed pursues a stable value services it can buy—and the rate
of the dollar and refrains from ex- at which money’s value falls is
cessive money creation. inflation.
Chart 1 provides evidence of the
Taxes or T-bills? close correlation between changes
in the money supply and the price
To understand the effects of level, which is used to gauge infla-
seignorage, one needs to understand tion. The chart plots the amount of
how government pays for its pur- currency in the hands of the public
plus bank reserves (base money) raise the seignorage “tax”?
and the U.S. consumer price index Such a temptation is tempered
for 1975 –93. The two lines are by market competition. The more
nearly perfectly correlated, indicat- inflationary monetary policy be-
ing that rapid growth of the supply comes, the less attractive the cur-
of fiat money lowers the dollar’s rency becomes as a store of value.
value through inflation. Dollarization occurs in some coun-
Between 1993 and 1994, the tries because the public doesn’t
United States raised about $31 bil- trust the local currency as a store of
lion through seignorage. This sum value, frequently because inflation
represents about 1.6 percent of in the country has been high in the
federal spending. On the surface, it past. So, the hint of inflation can
“ It is the commitment, might appear that a higher level of cause people to exchange one
not the commodity, seignorage would yield greater tax foreign currency for another that
savings for the U.S. taxpayer because seems more stable. In short, the
that makes paper money the Fed, in effect, could export dollar’s dominance could be lost
some of the seignorage “tax” to for- quickly if the Fed suddenly in-
hold its value —then eign countries. That policy, how- creased seignorage and caused
and now. The real ever, could have unintended results. people to question the dollar’s
standard is honesty, The Temptation to Tax Foreigners And if the Fed reversed its mone-
tary policy course, creating money
not gold.” Researchers have coined the term at a much faster rate, then exten-
“dollarization” to describe what sive foreign holdings of U.S. cur-
happens when the dollar or other rency could exacerbate the effects
foreign currency circulates along of inflation fears. As foreign dollar-
with a local currency.2 Estimates holders’ confidence in the dollar
indicate that U.S. currency circulat- eroded, they would trade dollars
ing abroad is between 50 percent for another currency they perceived
and 78 percent of the total, or be- as more honest, potentially en masse.
tween $187.5 billion to $300 billion In economic terms, demand for the
of the $375 billion in circulation.3 dollar would fall sharply, pushing
A comparison with the German inflation up even faster. If the Fed
mark highlights U.S. dominance as failed to reduce the supply of cur-
a supplier of currency to the world. rency to match the lower demand,
German marks in circulation today the inflationary consequences would
total about 250DM billion. Suppose, be made worse by the volume of
for example, that 33 percent of all U.S. currency being unloaded
marks were held outside Germany. abroad. The ensuing mass reversal
Then roughly 83DM billion, or, at of currency flows —from foreigners
today’s exchange rate, the equiva- to the United States —could prove
lent of about $52 billion, would be overwhelming.
held outside Germany. Even if all
marks in circulation today were Incentives for Honest Money
held outside Germany, they would
be equivalent to only about $167 The trust people around the
billion, still smaller than the most world are willing to place in the
conservative estimate of U.S. dollars U.S. dollar owes largely to the
circulating abroad. United States’ reputation for keep-
The volume of U.S. dollars circu- ing its promises and its track record
lating abroad means that non-U.S. of monetary stability. Through
citizens bear part of the seignorage seignorage, the dollar’s popularity
burden. And while a government abroad yields a dividend for Ameri-
that overtaxes its constituents may can taxpayers that was not avail-
be ousted at election time, nonciti- able under the gold standard.
zens holding dollars in foreign Proponents of the gold standard
countries don’t vote —so why not cite its low-inflation record. These
days, money’s stable value during Notes
the gold standard has come to be
associated with gold per se. How- Technically, the Treasury does pay
ever, the gold standard ultimately principal and interest on these debts,
but historically the Fed has returned all
worked because of restraint, the principal and interest payments to the Federal Reserve Bank of Dallas
restraint to hold gold’s dollar price Treasury. See W. Michael Cox, “Two
constant rather than make periodic Types of Paper: The Case for Federal Robert D. McTeer, Jr.
revaluations. In short, it is the Reserve Independence,” Southwest President and Chief Executive Officer
commitment, not the commodity, Economy, November/December 1992,
Helen E. Holcomb
for a description of the Treasury–Fed
that makes paper money hold its interaction.
First Vice President and Chief Operating Officer
value—then and now. The real 2 Harvey Rosenblum
At minimum, the country’s government
Senior Vice President and Director of Research
standard is honesty, not gold. can ensure some demand for its cur-
rency by requiring that taxes be paid W. Michael Cox
Thus, as long as the Fed can Vice President and Economic Advisor
maintain its commitment to honest in it.
See Richard D. Porter and Ruth A. Stephen P. A. Brown
money, the nation can enjoy the Judson, “The Location of U.S. Currency: Assistant Vice President and Senior Economist
benefits of a stable dollar. With so How Much Is Abroad?” unpublished Research Officers
much U.S. currency in circulation, mimeo, 1995. In addition, see Robert D. John Duca
the government could be tempted Laurent, “Currency in Circulation and Robert W. Gilmer
the Real Value of Notes,” Journal of William C. Gruben
to cash in through inflationary Evan F. Koenig
Money, Credit, and Banking 6 (2 1974):
money creation. But excessive 213–26. Laurent estimated that at most 2 Economists
seignorage hurts everyone holding percent of currency is lost, for example, Kenneth M. Emery
the currency. And while world by being at the bottom of rivers or David M. Gould
markets have selected the U.S. privately destroyed. Joseph H. Haslag
D’Ann M. Petersen
dollar as the currency of choice, Keith R. Phillips
that status could disappear quickly Stephen D. Prowse
if U.S. monetary policy stirred Marci Rossell
Fiona D. Sigalla
doubts about U.S. money. Lori L. Taylor
Honest money is the right policy. Lucinda Vargas
For both U.S. citizens and the rest Mark A. Wynne
Mine K. Yücel
of the world, honest money makes Carlos E. Zarazaga
good on the promise that a dollar
today will be worth a dollar tomor- Professor Nathan S. Balke, Southern Methodist
row, and honest money is what the University; Professor Thomas B. Fomby, Southern
Federal Reserve works to achieve Methodist University; Professor Kathy J. Hayes,
Southern Methodist University; Professor Gregory W.
by pursuing low inflation and prac- Huffman, Southern Methodist University; Professor
ticing restraint. Finn E. Kydland, Carnegie Mellon University;
Professor Roy J. Ruffin, University of Houston
—Joseph H. Haslag
W. Michael Cox • Mine K. Yücel
Gene Autry • Laura J. Bell
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