By W A Wijewardena –

Dr. W.A Wijewardena

Aseni, whiz-kid in economics, and her grandpa, Sarath Mahatthaya, ex-Finance Ministry Official, continue their discussion on crypto currencies and related issues. Their previous discussion had revolved around the creation of digital currencies in the modern era for easy use by people. Unlike physical currencies, digital currencies are invisible and intangible.

The first digital currency so created was the Special Drawing Rights or SDRs by the International Monetary Fund or IMF in 1969 with readiness to take over the role of the US Dollar in the event of it losing its global reserve currency status. However, SDR could not make that mark, and US Dollar continued to be the main reserve currency of the world even after the US Government unilaterally withdrew from the earlier commitment to convert dollars at a fixed rate of $ 35 per fine ounce of gold. Then, as a protest currency, to ensure a person-to-person payment bypassing the financial institutions, a digital currency based on a novel operating system called the blockchain was introduced in 2009. That was the birth of bitcoin, the forerunner to a new generation of digital currencies, that have now posed a threat to natural currencies issued by sovereign governments.

The value of bitcoin was to be ensured by curtailing its production mechanically. However, the very same feature caused the speculators to push up its value in terms of natural currencies. As a result, a bitcoin which was exchanged for 10 US cents in 2009 has now risen to about $ 60,000. This is not due to any increase in its intrinsic value but due to the speculative demand surpassing its production.

Today, the world is caught between a few dozen of these digital currencies and natural currencies being issued by sovereign governments. This has led to the challenging issue of what the choice of societies should be. The discussion continues:

Aseni: Grandpa, governments in many parts of the world are up in arms about the proliferation of digital currencies. Only the Government of El Salvador has approved the leading digital currency, bitcoin, as legal tender. Why are the governments against digital currencies?

Sarath: There are several countries that have banned cryptocurrencies. The list is getting added to day by day. The latest to enter the foray is China. In addition, Bolivia, Indonesia, Turkey, and Egypt had previously done so. This is quite natural because they are produced by private parties. Governments do not like their monopoly power being challenged by private parties. In early November, the US Treasury also released a report by an expert team that had recommended the US lawmakers to introduce urgently regulatory measures to check on the growth of these currencies which they had called stablecoins. These coins are no longer stable. But they are called stablecoins because that was the original objective of issuing them.

Aseni: But why should governments either regulate or ban them if they do provide a service to people?

Sarath: That is driven by two interests. One is the public interest to protect us as consumers and financial systems as drivers of modern economies. The other is a private interest to protect themselves. But the more predominant reason is this private interest.

Aseni: Wow! Government’s private interests? How can that happen?

Sarath: Governments make a huge amount of profits by issuing currency for use by people. In economics, this profit is called seigniorage. It is a word derived from old French meaning profits earned by lords by minting coins.

That is one of the most lucrative businesses in the world. When private parties issue currencies, they also stand to make profits. Governments do not like it. Therefore, all governments tend to use their sovereign powers to ban, regulate or eliminate them altogether. So, the private interest is to protect and keep the seigniorage for themselves.

Aseni: This is the first time I am hearing this word. How do governments make profits by issuing currency?

Sarath: This happens when the production cost of currency is less than its face value. We can take a very simple example to illustrate it. For instance, consider the 5,000 rupee note issued by the Central Bank on behalf of the Government. Though the face value is 5,000 rupees, its production cost is simply a negligible fraction of that value. It is about Rs. 10. Hence, every 5,000 rupee note brings about a profit of Rs. 4,990 to the Central Bank. But it enables the Government to appropriate that profit for itself by getting the private people to transfer their real assets to it. Suppose the government gets the Central Bank to print a 5,000 rupee note and use it to pay the day’s salary of a teacher. A teacher sacrifices five hours of her real labour in exchange of this piece of paper called a 5,000 rupee note. The teacher’s sacrifice is five real hours, but the Government’s sacrifice is only Rs. 10. That is how the Government benefits out of this transaction.

Aseni: Does it mean that this profit opportunity arises only in the case of paper money or coins where the metal value is less than the face value? I suppose that governments cannot earn seigniorage if the metal value of coins is equal to face value.

Sarath: Not exactly. There is historical evidence that kings too had tried to earn or enhance seigniorage by manipulating the metal base of coins issued. A good example is provided by King Parakramabahu the First who had reigned Lanka from 1153 to 1186 from Polonnaruwa as his seat of administration.

Sri Lanka’s foremost archaeologist and historian, Senarat Paranawitana, in his chapter contributed to vol II of the History of Ceylon published by the University of Ceylon has documented this. He says that the king had debased the gold coin with a cheap metal, copper, with the same face value. This is equal to devaluation of currency according to modern economic terminology. Paranawitana says that this strategy had allowed Parakramabahu to issue more coins, which modern economists call money printing. In addition, because of the cheaper metal value, the king had been able to grab more resources from private parties which we earlier called extracting seigniorage. Paranawitana has remarked that by issuing more copper coins, the king had stolen more wealth from people. This is inflation tax which modern economists call. See, Paranawitana has explained it beautifully without using any of the technical terms which economists use, such as devaluation, money printing, seigniorage, and inflation tax. However, King Parakramabahu, the First, had not been alone into this game. Ancient Roman Emperors were more notorious players of this game and it finally led to the collapse of that mighty empire.

Aseni: I see that seigniorage is at the centre of this controversy. Wasn’t there such a problem with SDRs?

Sarath: Indeed, there was. SDRs are a digital currency and therefore, the real resource use in its production is practically zero. You can imagine a current account department of a commercial bank to understand this. There, except the cost of printing cheque leaves and the operation of the clearing system, all transactions, creation of demand deposits and making payments, are done by means of book entries. Since cheques are being displaced pretty fast, that cost too is likely to be zero soon. Similarly, SDRs are created just by a decision of the Executive Board of the IMF. After that, all entries are made by means of book entries. Hence, there is no real resource cost involved compared to other reserve currencies. What this means is that seigniorage in SDRs is practically equal to 100 percent. Unlike the other digital currencies, the IMF distributes the seigniorage among its members. There, the problem is its unequal distribution. That is because the rich countries which have a higher shareholding, or a quota get a bigger allocation of SDRs than poor countries. Therefore, a bigger portion of seigniorage is apportioned to them leading to an unequal distribution of global wealth.

Aseni: How is the seigniorage distributed in the case of digital currencies produced by private parties and natural currencies issued by sovereign governments?

Sarath: In the case of digital currencies which are issued by private parties, the seigniorage is earned by those parties. In the case of natural currencies, the seigniorage is earned by sovereign governments that issue them. As a result, seigniorage involved in digital currencies is a private good. In contrast, seigniorage in natural currencies is a public good.

Aseni: I cannot understand it. Is it wrong for those private parties to produce a private good and earn profits out of it? How do they do it?

Sarath: First of all, there is nothing wrong for a private party to produce a private good and earn profits out of it. In this case, they earn profits by challenging the monopoly power of governments, and if it leads to general welfare of people, it should be encouraged and promoted. Private parties produce these private goods because the governments have failed to produce and supply quality goods.

We can understand how these private parties produce these private goods and earn profits by considering the operation of the very first digital currency, bitcoin. Its production is governed by a computer software based on algorithms built into it. Those who log into this computer system to produce bitcoin are called miners. They must make a real investment to produce them. That includes their own time, computing power, and electricity they use to run those computers. Mining of bitcoin is not a smooth business. It is hard and difficult to mine a bitcoin. If they are successful in mining a coin, they can have it. Their seigniorage is the market value of that bitcoin minus the cost of their real investment. At the time of introducing bitcoin in 2009, its market value was just 10 US cents. As a result, the seigniorage earned by those initial miners was not that much. But today with a market price of $ 60,000, they stand to earn a huge seigniorage. Those who buy bitcoin from the market do not earn seigniorage. They stand to earn capital profits or incur capital losses. The miners pocket out the seigniorage because it is a private good and private profit.

Aseni: What do the sovereign governments do when they earn seigniorage by issuing those national currencies?

Sarath: Seigniorage earned by governments is not direct as that earned by private parties. That is because the governments earn seigniorage through the interest income which central banks earn by investing the money created by them. The seigniorage is therefore equal to the net profits of a central bank, after one subtracts the cost of running a central bank from its gross earnings. Thus, it boils down to the net profits of a central bank. However, according to many central banking laws including our own Monetary Law Act, governments do not have the first right to central bank profits. Drafters of those laws have been smart species. They had known that if a free hand is given to governments, they would abuse that power. Therefore, when central banks make profits, there are certain restrictions imposed on the distribution of such profits. First, central banks should build up their internal reserves, meet the costs of high and unusual currency issues, and transfer to specific reserve funds which a central bank may create before transferring any remaining profit left to the government. There again, it should be done in consultation with the Minister of Finance either to reduce the value of Treasury bills held by the central bank or make a direct transfer to the Treasury.

Once the seigniorage is transferred, it becomes a part of the government revenue. Hence, unlike those private parties which can pocket out the seigniorage, the governments are supposed to redistribute it among citizens through the budget. That is why I said that seigniorage earned by those private parties is a private good which they can use in any way they like, and that earned by the Government is a public good that is used for improving the welfare of people.

Aseni: If the Government expenditure leads to improvement of people’s welfare. It is a good thing. But does it always happen? There are some criticisms about Government expenditure programs not aiming at people’s welfare but at the welfare of those in power. In that case, there is no difference between the private appropriation of seigniorage by private parties and the public appropriation not used for a public purpose. How do you respond to that issue Grandpa?

Sarath: You are correct. If there is no proper governance structure in society, public appropriation of seigniorage by governments does not lead to public welfare. But it is like robbing which Senarat Paranawitana said about King Parakramabahu, the First. The way to avoid it is to establish governance procedures correctly in society. It is not the fault of natural currencies but a weakness in the governance structure.

Aseni: I now understand it. It is this private interest which is behind the open animosity of governments against digital currencies produced by private parties. Have I correctly read the story?

Sarath: Yes and no. Yes, because we find evidence to prove that observation in the case of countries where there is a weak governance system. But we should keep in our mind, when private parties produce digital currencies, all those producers become separate central banks. Imagine a situation where all the citizens become miners of digital currencies. That is a waste of real resources. If we can produce the means of payment, the currency, with the least real cost, that is better for a country.

Digital currency systems are called decentralised financial systems or DeFi, pronounced as Dee Fai like wi-fi. Natural currency systems operated by central banks are centralised financial systems or CeFi. This is pronounced as Cee Fai. From the optimal resource use point of a society, CeFi may be a better option, if such digital currencies are produced by central banks. There are at least 81 countries which have started working on producing digital currencies which are called fiat e-currencies. They account for about 90% of the total global GDP. Among them, seven have already introduced their digital currencies. The latest entrants have been Nigeria which has introduced the digital form of its currency by the name of e-Naira, and China by the name of e-Yuan. The other five countries are all from the Caribbean region. Now it is a matter of time when the world will go for fiat e-currencies. But remember the main objective has been to keep the seigniorage for themselves which is at present appropriated by private digital currency producers as well.

Aseni: Isn’t it an evil objective Grandpa?

Sarath: In a way yes, but that can be applied to private digital currency producers as well. This is an instance where both parties suffer from robber’s mentality. This was presented in lucid form by German philosopher Emmanuel Kant. Robbers know that they do an evil thing, but to gain from robbery, they expect all others in society to be virtuous people. They cannot earn profits if all are robbers. Politicians in charge of governments and people engaged in digital currency production too have the same mentality. They want themselves to be an exception so that they can gain by robbing others. Suppose that everyone in society becomes a politician or a digital currency producer. Then, there is no prospect for super gains. To accumulate the super gain for themselves, they want the whole operation limited to themselves. To put it to a stop, information should be freely disseminated among citizens on exactly what is happening. But when it happens, governments use their sovereign powers to suppress it. Digital currency operators slander others who talk freely against them.

Aseni: I now understand the whole thing should be guided by a moral philosophy. As the Buddha said, one should not do any harm to another if he himself does not like it being done to him. If this moral message is well appreciated by all, they will refrain themselves from seeking to appropriate this super gain for themselves.

*To be continued…

*The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at waw1949@gmail.com