4.3 Seigniorage: The Revenue from Printing Money
So far, we have seen how growth in the money supply causes inflation. With inflation as a consequence, what would ever induce a central bank to increase the money supply so much? Here we examine one answer to this question.
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Let’s start with an indisputable fact: all governments spend money. Some of this spending is to buy goods and services (such as roads and police), and some is to provide transfer payments (for the poor and elderly, for example). A government can finance its spending in three ways. First, it can raise revenue through taxes, such as personal and corporate income taxes. Second, it can borrow from the public by selling government bonds. Third, it can simply print money. It does this indirectly—by selling bonds to the central bank and having the central bank issue new money to pay for the bonds.
The revenue raised by the printing of money is called seigniorage. The term comes from seigneur, the French word for “feudal lord.” In the Middle Ages, the lord had the exclusive right on his manor to coin money. Today this right belongs to the central government, and it is one source of revenue.
When the government prints money to finance expenditure, it increases the money supply. The increase in the money supply, in turn, causes inflation. Printing money to raise revenue is like imposing an inflation tax.
At first it may not be obvious that inflation can be viewed as a tax. After all, no one receives a bill for this tax—the government merely prints the money it needs. Who then pays the inflation tax? The answer is the holders of money. As prices rise, the real value of the money in your wallet falls. When the government prints new money for its use, it makes the old money in the hands of the public less valuable. Thus, inflation is like a tax on holding money.
The amount of revenue raised by printing money varies substantially from country to country. In North America, the amount has been small: seigniorage has usually accounted for only about 1 percent of government revenue. In Italy and Greece, seigniorage has often been over 10 percent of government revenue.4 In countries experiencing hyperinflation, seigniorage is often the government’s chief source of revenue—indeed, the need to print money to finance expenditure is a primary cause of hyperinflation.
CASE STUDY
American and Russian Inflations
Although seigniorage has not been a major source of revenue for either the Canadian or the American government in recent history, the situation was very different two centuries ago in the United States, and it has been very different in Russia recently. We consider first the American history.
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Beginning in 1775 the Continental Congress needed to find a way to finance the Revolution, but it had limited ability to raise revenue through taxation. It therefore relied heavily on the printing of fiat money to help pay for the war. The Continental Congress’s reliance on seigniorage increased over time. In 1775 new issues of continental currency were approximately $6 million. This amount increased to $19 million in 1776, $13 million in 1777, $63 million in 1778, and $125 million in 1779.
Not surprisingly, this rapid growth in the money supply led to massive inflation. At the end of the war, the price of gold measured in continental dollars was more than 100 times its level of only a few years earlier. The large quantity of the continental currency made the continental dollar nearly worthless. This experience also gave birth to a once popular expression: people used to say something was “not worth a continental” to mean that the item had little real value.
When the new nation won its independence, there was a natural skepticism about fiat money. Upon the recommendation of the first Secretary of Treasury, Alexander Hamilton, the Congress passed the Mint Act of 1792, which established gold and silver as the basis for a new system of commodity money.
The Russian ruble is another currency that has fallen precipitously in value. During the early 1990s, the former system of central planning was abandoned. But without a well-developed market system and without the trade that had taken place earlier with the other former Soviet republics, many factories found that there was no demand for their output. To avoid massive layoffs, the government simply printed up vast quantities of money to subsidize the operation of the factories. As the quantity theory predicts, prices began to soar. In the final months of 1992, for example, inflation was running at a rate of 1,300 percent per year. 