Seigniorage, Tobin tax, fiat money, gold and Bitcoin

It is obvious that fiat money leads to seigniorage income for the sovereign, but one would imagine that a decentralized open source money like Bitcoin (see my blog post earlier this month) would not allow anybody to earn seignorage income. When one examines the Bitcoin design, we find that it allows those with enough computing power to extract two forms of seigniorage income:

1. In the early years of Bitcoin, computing power allows the mining of new bitcoins. This is pure seigniorage.
2. When most of the coins have been mined, computing power can be used to charge transaction fees on every bitcoin transaction. This is also seigniorage income in the form of an all encompassing Tobin tax beyond the wildest dreams of the proponents of that tax.

Is this a design flaw or is it a necessary feature? After careful consideration, I think it is necessary. A monetary system can be sustained only if there are people with the incentive to invest in the maintenance of the system. In the case of fiat money, the sovereign expends considerable effort in preventing counterfeiting. One might think that commodity money like gold does not require such effort. But the historical evidence suggests otherwise:

1. After the collapse of the Roman empire, “within a generation, by about A.D. 435, coin ceased to be used [in Britain] as a medium of exchange ... although many survived as jewellery, or were used for gifts or for compensation.” (Christine Desan, “Coin Reconsidered: The Political Alchemy of Commodity Money”, quoting Peter Spufford.) With nobody having enough seigniorage income to try and maintain the system, commodity money was simply re-purposed to non monetary uses, and Britain relapsed into a barter economy.
2. Christine Desan also points out that a monetary system based on silver was reestablished centuries later by sovereigns who extracted seignorage income by charging a 5-10% spread between the mint and melting points of the metal.
3. On the other hand, Luther and White have several papers showing that after the collapse of the Somalian government, the old currency continued to circulate and local warlords maintained the money supply by counterfeiting the old currency notes to earn seigniorage income.

All this suggests that any form of money (whether fiat, commodity or a decentralized open source money like Bitcoin) needs some form of seigniorage to sustain it.

Posted at 10:17 pm IST on Sat, 27 Apr 2013         permanent link

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