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Fed's "Free" Money Cuts Debt by Billions

THE United States federal government has one extremely profitable business: It literally makes money.

Whenever the Federal Reserve System adds to its massive portfolio of Treasury securities - as it does each year in the process of creating new money - it indirectly generates profits for the federal government. Similarly, when the demand for fresh currency exceeds the amount of old currency turned in for burning or eaten by the dog, then the Bureau of Engraving and Printing becomes a profit center. Again, as the United States Mint stamps out new coins at a rate faster than old coins are worn out or lost,

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it nibbles into the federal deficit.

The revenue from such money creation is called "seigniorage." During the 1980s, the government earned some $112 billion from seigniorage (in 1982-84 dollars) - $11.2 billion a year on average, according to a study in the bimonthly Review of the Federal Reserve Bank of St. Louis. That's about the same amount Washington raises from estate and gift taxes each year.

Last year the Fed paid the Treasury $20.7 billion, mostly earnings from seigniorage. Seigniorage is free money for the government. It can spend it to buy highways or pay the wages of civil servants. It doesn't have to impose any taxes to get it.

In the 1981-90 period, seigniorage covered an average 1.6 percent of federal spending, according to the report by Manfred Neumann, a visiting scholar at the St. Louis Fed from the University of Bonn, Germany.

The term "seigniorage" dates back to the early Middle Ages. Rulers in many countries financed some spending with profits earned from minting new coins. Their face value was worth more than the gold or silver that went into the coins plus minting costs.

Today, the dominant factor in seigniorage is not minting coins. Rather it is the "open market operations" of the Fed. In order to expand the nation's money supply - defined as checkable accounts and currency in circulation - the Fed buys Treasury securities from the public. It writes a check covering the cost of the securities which the former owner deposits in his commercial bank. The Fed doesn't have to have any revenue or commercial bank accounts of its own to write that check; it just has to have a w orking check-writing machine. The commercial bank then uses a portion of that deposit to make loans or buy securities. New money has been created out of nothing. This money is the necessary fuel for the expansion of the economy.

By Mr. Neumann's calculations, the Fed bought an average $10.462 billion of federal debt a year in the 1980s.

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Another $455 million a year of seigniorage came from the interest the Fed pays to the Treasury on Federal Reserve notes that have been bought from the Fed by financial institutions. These are the paper bills in your wallet or pocketbook. The Fed paid an average of $15.954 billion to the Treasury a year in the 1980s. But then the Treasury paid interest back to the Fed on its portfolio of Treasury securities of $15.499 billion a year - leaving a net profit for the Treasury of $455 million.

In a way, the Fed's portfolio of US government securities can be regarded as nearly an interest-free loan to the Treasury. "Nearly" because in the accounting of interest on the Federal Reserve notes, the Fed subtracts its operating expenses - $746 million a year on average in the 1980s.

After paying its own expenses, the US Mint made a profit of $587 million a year in the 1980s.

To finish the calculation of total seigniorage, Neumann subtracts $302 million a year to account for growth in the Treasury's deposits with the Fed. The Fed acts as a bank for the Treasury. So the Treasury must keep deposits with the Fed.

Some governments have tried to cover budget deficits by boosting seigniorage. They order their central banks to finance some of their deficit spending. This soon creates inflation.

The Fed is independent of the Treasury, however. If it so chooses, the Fed can create enough new money to boost inflation and seigniorage. Neumann calculates, though, that when inflation reaches 7 percent, seigniorage begins to decline at a rate of $1.4 billion for each percentage point above 7 percent.

"You may hurt yourself rather than help yourself" with too much inflation, says St. Louis Fed economist Daniel Thornton.

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