The other day I was reading The Daily Reckoning, Bill Bonner's email newsletter sent out to Gary North's mailing list, when a commentator mentioned "seignorage," the markup the government makes on the difference between the value of a $20 bill and the cost to produce it. This is not a new concept, but for me it was like a light bulb going off. Gary North and others have been trying to explain why a paper money system, even if it is backed by a "gold standard," inevitably leads to government confiscation. It occurred to me that the term "seignorage" may be the simplest way to understand it.
To start the discussion, let us temporarily accept the concept that governments have a monopoly on the supply of money. The government of South Africa, for example, manufactures Krugerrands. In this case the seignorage value, the difference between the value of the gold content and the price of the Krugerrand, is a comparatively small percentage. That government is performing a valuable service and making a reasonable profit. Investors all over the world buy Krugerrands freely, of their own volition, without government coercion.
This was the original basis of the seignorage system. Governments produced a real good – coins that contained true intrinsic value, whether gold or silver or copper – which could then be exchanged for other goods of real value such as food and clothing. Governments were supposed to supply an equal value of coinage for the money, and throughout some historic periods competition provided a series of checks and balances. In modern terms, if South Africa were to dilute the gold content of the Krugerrand, people would simply stop purchasing them and buy Canadian Maple Leafs, or something similar.
In John Donne's Elegy XI upon the loss of his 12 gold coins we see the process at work by which governments are continually tempted to debase their currency, yet are constrained by competition to provide some content of intrinsic value:
Oh shall twelve righteous angels, which as yet No leaven of vile solder did admit… Were they but crowns of France, I cared not, For, most of these, their natural country rot I think possesseth, they come here to us, So pale, so lame, so lean, so ruinous. And howsoe’er French kings most Christian be, Their crowns are circumcised most Jewishly. Or were they Spanish stamps, still travelling, That are become as Catholic as their king, These unlicked bear-whelps, unfiled pistolets That, more than cannon shot, avails or lets, Which, negligently left unrounded, look Like many-angled figures in the book
Each European country produced gold coins, but some were recognized as more dependable, while others were suspected of being debased. But once any government is given an absolute monopoly, they no longer have any incentive to produce real goods of true intrinsic value. They are guaranteed a set price for their product, so the more they can cheapen the product, the greater their profit. To see the incentive for chicanery, we need merely ask, "What if an ordinary company were to be given a similar deal?"
What if taxpayers were required by law to pay for, say, Compaq computers, while Compaq was required to deliver something, but there was no way to monitor the quality of Compaq's delivered products? Compaq would know that the consumer would pay them so much money each month, whether or not the product actually worked. In fact, the product didn't even need to contain any actual computer chips, it just had to bear a surface resemblance to the promised item.
Naturally they would realize that delivering cheap plastic or paper facsimiles of computers would allow them to make the maximum possible gross margin. The pressure to do so would be irresistible, and the result would be inevitable. How could a chairman tell his board of directors that he was going to continue supplying working computers at a minimal profit margin, when he had the opportunity to make virtually 100% profit by delivering cheap replicas instead?
It would be a bad thing if Compaq were not delivering real computers, even worse if farmers stopped delivering real food. But it's the worst of all when the government does the same thing to money, because money is the basis for all economic exchange, and so the government is debasing every part of society. Every industry, every transaction is affected.
To test our seignorage theory, let's look at other areas where government has a monopoly and see if the same principles are at work. The two most important which occupy the largest percentage of national income would be education and national defense. In both cases, the government owns either an outright or a virtual monopoly. The government's monopoly on education is not reduced by the existence of private schools since all citizens must pay for the schools whether they use them or not. Parents who send their children to private schools are required to pay twice.
Let us assume for the sake of argument that at one time the government delivered real education, just as at one time governments delivered real gold coins to their citizens. But over time, how long would it take government educators to realize that they would get paid the same, and that their income was guaranteed by the force of law, whether they delivered a viable product or not? In the same way that governments discovered that they could vastly increase the seignorage value of money by delivering paper instead of gold for the same price, wouldn't governments discover that they could deliver a mere simulacrum of education as well? After all, property taxes do not rise or fall based on the knowledge level of students. On the contrary, over the past 40 years there has been a consistently inverse relationship in which expenditures increase while academic performance falls.
John Senior points out in his book The Death of Christian Culture that in the 19th century 16-year old students were required to write essays in ancient Greek. As he says, they weren't necessarily brilliant essays, nor was the ancient Greek necessarily flawless. But they could do it. That was what was meant by receiving an "education."
Educated men of the founding fathers' generation believed that the measure of an educated man was that he would be capable of holding a conversation with educated men of the past, men like Aristotle, Cicero, and Augustine. An educated man of that generation could do so, and in the original language. In Henry Fielding's 18th-century novel, Joseph Andrews, the parson says to a fraud who claims to be educated, "Why, if my 8-year old boy could not construe Greek better than you, I would give him a flogging." Virtually no one in today's society receives that level of education, despite the expenditure of enormous sums of money that are beyond the wildest imaginations of former centuries. How many Americans would feel confident conducting a dialogue with Alexander Pope or Dr. Johnson without embarrassing themselves?
Back in the 19th century when the pound sterling was as good as gold, the word "education" meant something specific to the inhabitants of Tom Brown's School Days. Now that the pound has been reduced to only a fraction of its former glory, and even that fraction is based on "faith and credit" rather than intrinsic value, education in a similar fashion has been debased to a level that would be hardly recognizable to a citizen of that time.
It's true that some young students are knowledgeable in areas of technical information that did not exist back then. But in America at least, that knowledge is usually gained through private initiative outside the formal education system upon which the government lavishes so much public expenditure. The science taught in most schools consists primarily of indoctrination in certain ecological principles. And even in the technical fields, virtually all of our science PhDs are being earned by foreign-born students.
Our other proposed example of government seignorage was national defense. Once again we see phenomenal public expenditures in an area in which the government has a monopoly. But the question is, "Do we receive anything recognizable as defense?" In the education field the government has demonstrated that a seemingly infinite expenditure on scholastic-related products is not capable of producing true education. Likewise in the area of national defense, virtually infinite expenditures by the government seemingly cannot defend the United States.
If the United States had not one soldier in its army, nor even 1 plane in its air force, would we be in any danger of foreign aggression? Would we need to fear imminent invasion from Canada or Mexico? Would England or France take advantage of the opportunity to launch a pre-emptive strike? Would even the ultimate bogeyman, the former Soviet Union, pose any threat?
Compare this situation to what we experience today. In place of the "no standing army" rule envisioned by the founding fathers, we have a massive military, greater in might than all the competing militaries of the world. Yet we suffer under constant, unremitting threats, according to our federal government, which considerately informs us of the daily threat level, whether "Level Orange" or "Level Red." We are unable even to perform the job which was done by the rudimentary Coast Guard system that existed in the United States before the days of massive military buildups – protect our own borders from a massive influx of illegal immigrants and illegal drugs, although we are capable of obliterating virtually any city in the world, a task in no way truly related to the defense of our homeland.
In the case of both education and defense, a reader might point out that the government does purchase something with all that money. From education departments we get thousands of school buildings, hundreds of thousands of teachers, countless numbers of books. From the defense department we get hundreds of millions of dollars worth of guns, planes, bombs, etc. The money is being spent somewhere, after all.
But the correct question to ask is not whether there is a lot of activity going on, but whether the ultimate product is being delivered. Historically, when governments started to deliver paper money in place of gold, they did not go out of business. Rather they initiated a new era of vast governmental expansion which we are continuing to live through. The scope of national government activity increased in direct proportion to the vastly increased seignorage value of their debased currencies.
If Compaq were allowed to deliver paper facsimiles of computers, would all activity at corporate headquarters disappear? On the contrary, the activity would actually increase as the company enjoyed the ability to play with 99% gross margins. More employees would be hired. All the managers would get raises. Bigger buildings would be built. The manufacture of paper computers would be presented as a task of consummate skill and difficulty.
We see an analogous situation with money. The machinery of the government-operated financial system is infinitely larger and more complex than anyone could have imagined in past times. Enormous amounts of monetary products are produced and distributed by a system that is perfectly understood by no one apparently, not even by the people running the system.
Where does money come from and how does it operate? When should we supply more of it and when should we supply less? Who owns the Federal Reserve and who benefits from the profits? These are all deep mysteries, but the plain and obvious fact is that in the field of money supply, just as in the areas of education and defense, enormous activities take place, in which large amounts of currency change hands.
The only real question is whether any true money is delivered. Sure we have lots of pieces of paper floating around, and lots more digital representations, but does the government actually supply us with any implements of intrinsic value that we can trade for other items of intrinsic value? In the same way, we can ask, "Do we get education?" Does anyone other than the immediate beneficiaries (administrators, teachers, contractors) have any use for all these buildings, books, computers, etc? And do we get defense? Are the citizens of our country actually protected from foreign invasion by all this military-related activity, or are we instead made more vulnerable?
Ludwig von Mises pointed out that a fundamental problem with a socialist system is that in the absence of price indicators there is no way to tell what is wanted and needed. The Soviet Union, for example, may have exceeded their quota for tractors every year, but lacked fuel to operate them. Tractor production was considered a good in its own right, whether or not any food was produced with the tractors. Vast efforts were undertaken, but there was no way to know if they were fulfilling their ultimate purpose.
Our own government systems of money, defense and education operate in precisely the same fashion. Vast efforts are expended but there is no way to know whether we want more paper money, more school buildings, or more fighter planes, or whether these things are achieving their ultimate purposes. Alan Greenspan decides how much to increase the money supply based on his own inscrutable logic. School systems decide to construct new buildings and hire more teachers without any feedback from a competitive system. When was the last time that you went down to the store and decided that the F-117 stealth fighter was a better value than the older F-16 fighter plane? These decisions are made in an economic vacuum not significantly different from the Soviet economy.
Hopefully these 3 examples demonstrate that the seignorage concept is a convenient way to visualize the problems with government-supplied products. Government owns a markup on the products it delivers, and there is a built-in incentive to maximize this markup, as there is for all companies and products. But for the government, there are no balancing incentives that force them to deliver full value for the money. On the contrary, there are inevitable and irresistible incentives to debase the product to the greatest extent possible. History has shown that the government's ability to debase the product is very great indeed, in fact virtually limitless.
June 6, 2003
