Tuesday, 12 July 2016

Seigniorage profits made by private banks.


Seigniorage is defined in the Oxford Dictionary of Economics (2009) as “The profits made by a ruler from issuing money”. I suggest the word “ruler” is superfluous there. I.e. seigniorage is the profit made by ANYONE who issues or prints money, including for example, a backstreet counterfeiter. At any rate, I’ll use the word in the latter sense.

As to how backstreet or traditional counterfeiters make a profit, that’s obvious enough: they print $100 bills for example and buy consumer goodies with those bills. I.e. they get $100 worth of real goods in exchange for a piece paper. Nice work if you can get it.

But private banks also issue a form of money. As the opening sentence of a Bank of England article entitled “Money creation in the modern economy” puts it, “This article explains how the majority of money in the modern economy is created by commercial banks making loans.”

However, private banks clearly do not do the same thing as traditional counterfeiters: use the money they create to buy consumer goodies. Instead, they lend out that money at interest.

So is there any sort of seigniorage profit there? Well the answer is: yes. The way that profit comes about was explained in a rather stylized way by Messers Huber and Robertson in their work “Creating New Money”.

As they put it, “Allowing banks to create new money out of nothing enables them to cream off a special profit. They lend the money to their customers at the full rate of interest, without having to pay any interest on it themselves. So their profit on this part of their business is not, say, 9% credit-interest less 4% debit-interest = 5% normal profit; it is 9% credit-interest less 0%debit-interest = 9% profit = 5% normal profit plus 4% additional special profit. This additional special profit is hidden from bank customers and the public, partly because most people do not know how the system works, and partly because bank balance sheets do not show that some of their loan funding comes from money the banks have created for the purpose and some from already existing money which they have had to borrow at interest.”

That explanation by Huber and Robertson is unrealistic, and doubtless deliberately so. Banks do not of course lend to the majority of borrowers at the normal rate, and lend to another lot at 4% less than the normal rate. Rather, the ability of private banks to create a certain amount of new money almost every year enables them to lend at a lower rate than if they had to obtain money the way most of us do: doing some sort of work and saving up.

And no doubt competition between banks means that lower rate is enjoyed to some extent by borrowers rather than all of it going straight to banks’ bottom line.

But the fact remains, that private banks’ freedom to print money benefits those banks, and those they lend to.


So who loses out?

There are no free lunches in this world. I.e. the latter extra profit for banks and borrowers must come from somewhere. And where it comes from is not too difficult to work out.

Assume, just to keep things simple, that the economy is at capacity (i.e. full employment) prior to private banks being granted the right to create money. Assume that banks are then granted the latter right. The extra lending will boost demand. But that’s not permissible without inflation rising too much, given the above assumption that the economy is already at capacity.

So to counteract the inflationary effect of that new borrowing, government would have to implement some sort of DEFLATIONARY measure, like raising taxes or cutting public spending. In that case, those paying for the above increased bank profits and reduced interest for borrowers would be taxpayers or the recipients of public spending.

An alternative would be for the central bank to raise interest rates. But to do that, taxes would have to be raised there as well - to pay for the interest going to those with cash to spare who decided to buy the new state issued high interest bonds. So again, taxpayers pay a price.


Conclusion.

Private banks do actually make seigniorage profits but no quite in the same way as traditional counterfeiters. In the case of private banks, the profit is earned in much more circuitous way.

I’ll leave the last word to the French economics Nobel laureate, Maurice Allais:

“In reality, the ‘miracles’ performed by credit are fundamentally comparable to the ‘miracles’ an association of counterfeiters could perform for its benefit by lending its forged banknotes in return for interest. In both cases, the stimulus to the economy would be the same, and the only difference is who benefits."


13 comments:

  1. I saw you palm that card. Assuming for the sake of argument that the economy is a full employment when real actual economies are almost never actually anywhere close to full employment, especially recently, doesn't make much sense in today's world. Then you completely ignore the normal state of affairs and declare the win. Nope. Can't do that and convince me of anything much.

    ReplyDelete
    Replies
    1. I was using the phrase "full employment" in the sense that economists normally use the phrase, i.e. something like "the lowest feasible level of unemployment that is possible without inflation taking off". That's very roughly 5% unemployed: certainly not anything near 0% unemployed. The other measure of capacity is where inflation is above the 2% target. On that basis, and given that inflation has been above 2% most years since WWII, then the economy has been at or near capacity most years.

      Delete
    2. "I was using the phrase "full employment" in the sense that economists normally use"

      I know what sense economists normally use it it. I think calling that "full employment" is nonsensical and using it in an argument is also nonsensical.

      A meaningful definition would be that full employment exists when everyone who wants a job either has one or is in a short interval between leaving one job and starting another one. And that hardly ever happens and certainly isn't happening anywhere right now. Well maybe there is an exception somewhere that I haven't heard of, but if so it will be an exception, not the normal case.

      I think M.M.T. has shown fairly convincingly that the latter form of F.E. is achievable without inflation taking off.

      Delete
    3. Ed,

      I understand you don't believe we are at or have been at full employment for a long time; however, I don't think that takes away from Ralph's analysis or conclusion in any way.

      It is common practice in economics, mathematics, science, etc. that you attempt to isolate one variable, by making other potential variables constant. In this case he was only assuming full employment for simplicity.

      The main point of Ralph's article was about Bank's making seniorage profits when they when making loans, by creating money/deposits . Are you are stating that banks do not make seniorage profits when the economy is not at full employment (based on your definition of "full employment). If not, the full employment distinction is not material to the point Ralph was making.

      Delete
  2. So what are central bank interest rates? I had always thought this was the interest charged when private banks borrowed from the central bank, as in when they create money. What do you think of this as an alternative, where money creation comes at a cost that can be redistributed in the economy.

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    Replies
    1. Don't really understand your question, however....Yes: CB interest rate is the rate they charge for lending to private banks.

      Re the cost of creating money, one big advantage of state created money is that it is virtually costless. In contrast, money creation by private banks involves a significant cost in that private banks have to check up on the credit-worthiness of those they supply money to, and/or get collateral off the latter.

      Your point about me not considering the scenario where the economy is NOT AT capacity is very reasonable I think. I'll add a "PS" to the above article in a day or two to try to take account of that point.

      Delete
    2. In regards to the original poster's question, I think he/she is confusing two things.

      However, I am writing from the U.S. and unfortunately don't know how it works in England, but, will do my best to explain how it works in the U.S.

      There are two primary Central Bank rates in the U.S. (We call our central bank the federal reserve). The fed funds rate is the target rate for banks at which banks should lend to each other and the discount rate is the target rate for banks to borrow from our central bank, hopefully, as a lender of last resort. There are two type of what is called "high-powered" or actual money in the economy, currency (cash and coins) and central bank reserves. When the central bank wants to increase the central bank reserve portion of the money supply it buys assets from banks and credits their account at the federal reserve, thus, increasing the money supply. What I find appalling though is banks can borrow from the Fed at such a low rate (for quite a while it hovered at half of 1%) and then turn around take that money and buy government bonds (what we call treasury bills and notes, that return 2%-3%) and make a nice spread. So the government cuts the banks a sweetheart deal providing them with almost free money to stimulate growth and rather than lend it into the economy to small business, the banks turn around and say, thank you very much, we'll buy government bonds and make money on the spread. I'd love to borrow $100 million from the Fed at .5% invest it in treasuries and make the 1.5% to 2.5% of $100 million ($1.5 / $2.5 million per year)!!!

      I think the point that Ralph was making when he said that banks create money is that when banks want to make a loan they don't have to wait for a depositor, like most economics textbooks describe, they can make the loan for $5,000 (an asset) and then with a couple of key strokes in the computer create a checking account with a new $5,000 balance for you to spend. Instead of having to pay a depositor, for example, interest on his/her money, which will be lent to the borrower, the bank can realize the entire interest income as profit, with no interest expense, thus, inflating its net interest income.

      Hopefully that answers your question.

      Delete
  3. This cr*p blog system is no longer posting comments properly, so I’m doing it manually.

    Ed says:

    "I was using the phrase "full employment" in the sense that economists normally use"


    I know what sense economists normally use it it. I think calling that "full employment" is nonsensical and using it in an argument is also nonsensical.


    A meaningful definition would be that full employment exists when everyone who wants a job either has one or is in a short interval between leaving one job and starting another one. And that hardly ever happens and certainly isn't happening anywhere right now. Well maybe there is an exception somewhere that I haven't heard of, but if so it will be an exception, not the normal case.


    I think M.M.T. has shown fairly convincingly that the latter form of F.E. is achievable without inflation taking off.

    Ralph says:

    There are an infinite number of possible definitions of unemployment. Obviously zero unemployment under your “meaningful” definition would be nice. But that’s just not the real world. In the real world we face a problem namely that inflation kicks in when unemployment is well above your “meaningful” rate. It’s that brute reality which I dealt with above: i.e. I dealt with where “full employment” as per economists’ standard definition (the point at which inflation kicks in). Or rather I deal with an assumed scenario where unemployment was as low as it could go before inflation kicks in.

    Re MMT and job guarantee, JG can in theory reduce unemployment to literally zero. But I was assuming just standard forms of employment rather than non-standard forms like JG. JG is a vastly more complex issue than 95% of its advocates seem to think. It tends to involve relatively unproductive forms of work and it’s expensive to administer and run. Whether it’s worth doing is debatable. See e.g.:

    http://ralphanomics.blogspot.co.uk/2012/08/job-guarantee.html and
    http://ralphanomics.blogspot.co.uk/2014/02/mitchell-and-wrays-flawed-ideas-on-job_2247.html


    ReplyDelete
  4. Well banks do pay interest on timed deposits,so they do pay some interest out ,though it will be very low.It will not be 0%.

    Overall though I agree ,banks have a huge privilege from issuing new money.This was once an exlusive perogative of kings and rulers,but somehow in the mists of time,bankers inserted themselves in the deal and the kings were happy to allow it.Probably becuase it took the heat out of having to raise taxes from an increasingly restless population.

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    Replies
    1. Vincent, Re your point about banks paying interest (at least on term accounts): Warren Mosler raised that as an objection to my claim at our meeting in April that banks profit from seignorage. I.e. the "Mosler objection" is “banks pay interest on money deposited with them, ergo banks have to pay to access money, ergo there’s no seigniorage profit.” I think the flaw in that argument is best illustrated by comparing banks to car hire firms, as follows.

      Banks hire out something: money. Car hire firms hire out something: cars. If car hire firms found some very low cost way of obtaining cars (e.g. UK car hire firms went over to France, stole cars and shipped them back to the UK), there is no question but that that would be a boost for the UK car hire industry. The fact that AFTER stealing a given collection of cars, car hire firms competed among themselves (and with other car users) for access to those cars doesn’t alter the fact that the initial act of stealing them would be a boost for the UK car hire industry.

      When I say “compete among themselves and with other car users…” what I mean is that there is a never ending market in used cars and a HUGE daily turnover in that market. E.g. if a particular car hire firm thinks it can make profitable use of more cars, it may buy new cars, or it may bid cars away from others (including other car hire firms) in that second hand market.

      Delete
  5. Well I personally would say Mosler is wrong.For a start banks only pay out interest to keep their loans equal to deposits,it is a balancing act after the event.So having produced the money out of nowhere on which to charge interest they then try to hang on to as many deposits as they can.(and pay a lower interest rate on only some of that)Deposits area cheap form of borrowing for banks.Seems to me this is a very favourable position to be in.Yet they still ballsed it up.
    And I agree with your analogy too.The first use of new money is always the seigniorage benefit,because the intiator of currency gets the first use of it.Pity banks do not have to go and get that money from somewhere else before lending it out rather than just create it at will.After all four Nobel Prize Laureates in econmics agree on this.

    ReplyDelete
  6. This blog system is playing up again: it won’t post comments. Problem seems to be just on this post. Anyway here’s two comments by Jack Haze which I’m placing here manually.

    Jack’s first comment:

    Ed,

    I understand you don't believe we are at or have been at full employment for a long time; however, I don't think that takes away from Ralph's analysis or conclusion in any way.

    It is common practice in economics, mathematics, science, etc. that you attempt to isolate one variable, by making other potential variables constant. In this case he was only assuming full employment for simplicity.

    The main point of Ralph's article was about Bank's making seniorage profits when they when making loans, by creating money/deposits . Are you are stating that banks do not make seniorage profits when the economy is not at full employment (based on your definition of "full employment). If not, the full employment distinction is not material to the point Ralph was making.

    Jack’s second comment:

    In regards to the original poster's question, I think he/she is confusing two things.

    However, I am writing from the U.S. and unfortunately don't know how it works in England, but, will do my best to explain how it works in the U.S.

    There are two primary Central Bank rates in the U.S. (We call our central bank the federal reserve). The fed funds rate is the target rate for banks at which banks should lend to each other and the discount rate is the target rate for banks to borrow from our central bank, hopefully, as a lender of last resort. There are two type of what is called "high-powered" or actual money in the economy, currency (cash and coins) and central bank reserves. When the central bank wants to increase the central bank reserve portion of the money supply it buys assets from banks and credits their account at the federal reserve, thus, increasing the money supply. What I find appalling though is banks can borrow from the Fed at such a low rate (for quite a while it hovered at half of 1%) and then turn around take that money and buy government bonds (what we call treasury bills and notes, that return 2%-3%) and make a nice spread. So the government cuts the banks a sweetheart deal providing them with almost free money to stimulate growth and rather than lend it into the economy to small business, the banks turn around and say, thank you very much, we'll buy government bonds and make money on the spread. I'd love to borrow $100 million from the Fed at .5% invest it in treasuries and make the 1.5% to 2.5% of $100 million ($1.5 / $2.5 million per year)!!!

    I think the point that Ralph was making when he said that banks create money is that when banks want to make a loan they don't have to wait for a depositor, like most economics textbooks describe, they can make the loan for $5,000 (an asset) and then with a couple of key strokes in the computer create a checking account with a new $5,000 balance for you to spend. Instead of having to pay a depositor, for example, interest on his/her money, which will be lent to the borrower, the bank can realize the entire interest income as profit, with no interest expense, thus, inflating its net interest income.

    Hopefully that answers your question.



    ReplyDelete
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