Federal Reserve Accounting and Its Solvency
To understand why, we need to look more closely at the relationship between the flows in the Fed’s income statements and the stocks reported in the Fed’s balance sheet. The Fed’s income primarily consists of interest earnings (and any capital gains) on its assets, whether Treasury securities, loans, or private securities. That income is used to cover the Fed’s operating expenses and to pay a fixed dividend of 6 percent on the “shares” owned by member banks, with most of the residual kicked back to the Treasury. Thus, during calendar year 2009, the Fed’s total income was $63.1 billion. Of that, operating expenses (including interest paid out) accounted for $9.7 billion, dividends paid to member banks for $1.4 billion, increases in the Fed’s capital account (about which more later) for $4.6 billion, and remissions to the Treasury for $47.4 billion (or 75 percent of the total).
What makes these transactions unlike those of any private firm or household is that they are nearly all conducted in the Fed’s very own liabilities: dollar-denominated notes and Fed deposits. Moreover, these are not genuine liabilities, being only claims to more of the same. Assume for a moment that the Treasury pays any interest it owes to the Fed in the form of dollar bills it has just received as taxes from the general public. Because those dollars when outstanding were listed as liabilities on the Fed’s balance sheet, the payment will have no impact on the total balance sheet, so long as the Fed takes no further action. Outstanding Federal Reserve notes along with the monetary base will fall by the amount of the payment, and the Fed’s capital account rises by the same amount. Total assets remained unchanged on one side of the balance sheet as will total liabilities plus net worth on the other side. Only if the Fed employs this income to purchase further assets does the balance sheet increase, with assets rising on one side by the same amount as the capital account on the other, while total outstanding liabilities (and the monetary base) remain constant. This later scenario is analogous to what usually happens in the short run to the balance sheet of private firms, whose dollar income is obviously not in the form of their own liabilities. Yet in either scenario, the flow of income to the Fed initially shows up as an increase in its capital account.
Of course, the Treasury does not pay interest to the Fed with actual dollar bills, much less ones that it has just acquired. When the Fed earns any interest on assets that have been privately issued, the payment is in the form of a check, or its equivalent, written against some bank. But the check is a claim on bank reserves, which are interchangeable with currency, so the process works out pretty much the same as above, with any initial decline appearing in the reserve component of the monetary base rather than the currency component. Although the Treasury, like private parties, has what are called “tax and loan” accounts at private commercial banks, these accounts are used mainly for the deposit of tax revenue rather than for Treasury payments. The rationale for the tax and loan accounts is to diminish the impact of tax payments on the total reserves of the banking system.
Treasury payments, in contrast, are made from Treasury deposits maintained at the regional Federal Reserve banks. Funds are routinely funneled out of the tax and loan accounts into these deposits before they are paid out to cover Treasury expenditures. These deposits, however, are just another liability of the Federal Reserve, although in this case one that does not count as part of the monetary base. So with no further action by the Fed, much as in the first scenario above, a Treasury interest payment would cause its deposits to fall by the same amount that Fed capital rises, with no change either in the Fed’s balance sheet totals or the monetary base. If the Fed on the other hand uses the payment to acquire a net asset, as in the second scenario above, the balance sheet totals and the monetary base go up by the amount of the payment. Except for the differing impact on the monetary base, everything else therefore works out the same as if the payment had been made in dollar bills.
Now just reverse all these transactions when the Fed remits its residual earnings to the Treasury. Treasury deposits at the Fed will go up with an equal and offsetting decline in the Fed’s capital account. If the Fed takes no further action, balance sheet totals are unchanged. If the Fed sells off assets decreasing the monetary base, balance sheet totals fall by the amount of the remittance. However, decisions about monetary policy dominate changes in Fed assets and the base, with the Fed easily offsetting any perturbations arising from earnings and remittances, leaving no discernable impact on the base. To top that off, since excess earnings are distributed to the Treasury on a weekly basis, the amounts involved are trivial, when compared to the size of the Fed’s $2 trillion plus balance sheet, and never amount to more than a few billion dollars.
Which brings us finally to the January 6 announcement. It has brought about two related changes in the accounting procedures, neither of which seems at first glance to be significant. First, the residual earnings slated to go to the Treasury are now listed not as surplus capital but instead as a separate liability, somewhat misleadingly labeled “Interest on Federal Reserve notes due to U.S. Treasury.” (The label is misleading because Federal Reserve notes actually earn no explicit interest for the Fed, nor does the Fed’s remittance to the Treasury bear any direct relationship to the amount of Federal Reserve notes outstanding.) This new liability gets its own line toward the bottom of the H.4.1 release in the “Statement of Condition of Each Federal Reserve Bank,” which gives individual balance sheets for each of the twelve Fed district banks, but is lumped into the category of “Other liabilities and accrued dividends” in the “Consolidated Statement of Condition of All Federal Reserve Banks,” which combines the balance sheets over all districts and sits just above in the release. In other words, a trivial item that once showed up as fluctuations in the capital account now shows up as a fluctuating liability.
The second change in the January 6 announcement requires a closer look at the Fed’s capital account. Both before and after the announcement, the account has been subdivided into three categories: “Capital paid in,” “Surplus,” and “Other capital accounts.” The last of these three is where the residual earnings to be remitted to the Treasury used to show up, but now that they have been shifted into a liability, the amount in “other capital accounts” has so far stayed at zero. “Capital paid in” refers to the nominal shares, mentioned above, that member banks hold in the district Fed where they are located. These shares are fixed in value and cannot be resold on a secondary market; and the amount each member bank must purchase is required to equal 3 percent of the bank’s own capital. So rather than representing true ownership, it is more accurate to think of these shares as a bond-collateral requirement once removed. The banks must invest in the Fed, which in turn buys Treasury securities. The banks then get a fixed 6 percent dividend out of the Fed’s earnings. Whether that return is a good deal or not depends on prevailing interest rates and where the banks that are members of the Fed might have invested their funds otherwise.
As banks change in size or join and leave the Fed, the number of such shares can grow (or shrink), and consequently so does the amount of “capital paid in.” But the Federal Reserve Act further required the total capital of each district Fed to be twice the amount of capital paid in by member banks, and that additional amount is listed in the Fed’s capital account as “surplus.” In essence, this represents retained earnings, a small part of the Fed’s income that does not cover operating expenses and yet is not remitted to the Treasury. Prior to the January 6 announcement, the amount of surplus capital was only adjusted to exactly equal (as required by law) the amount of capital paid in at year’s end, so the two could vary slightly from week to week. But as a result of the January 6 change, these two amounts are being equalized on a daily basis. And doing so necessarily alters slightly the liability shown as owed to the Treasury. For some of the Fed’s twelve districts, therefore, the category of “Interest on Federal Reserve notes due to U.S. Treasury” can temporarily appear as negative, although this washes out for the system as a whole. In short, both of these changes result only in minor shifts in where the flows of Fed income and payments temporarily show up on the balance sheet.
It is true that these two changes could affect how the Fed’s balance sheet reports any losses. What if the Fed’s portfolio of mortgage-backed securities and other risky assets reduces its income so low that its residual earnings completely disappear and turn negative? Such losses conventionally would cause first a decline in the Fed’s surplus capital, and when that is wiped out, a decline in the paid-in capital of member banks. The worry is that the January 6 change will now permit the Fed instead to book losses as a negative liability, appearing to leave the capital account untouched. However, if the Fed can now permanently carry a negative liability on its balance sheet, it could have just as easily permanently carried a negative entry for “other capital accounts,” with the same result: no decline in paid-in and surplus capital. Admittedly, total capital would still have registered a decline. But the reason the Fed can easily get away with either form of accounting legerdemain is because its income and payments are in its own liabilities. Consequently, the Fed cannot de facto go bankrupt (at least unless the Treasury or the entire U.S. government does as well). It can continue to cover its operating expenses, to buy more assets, or even to make subventions to the Treasury simply be increasing the monetary base, ad infinitum.
In this respect, the Fed is like the Treasury, which issues that part of the monetary base consisting of coins. Indeed, it is at least conceivable that the Treasury, on its own, could generate severe inflation by minting lots of quarters and dollars. Despite the fact the pennies and nickels now cost more to produce than their face value, the U.S. Mint’s operations overall still generate positive seigniorage, which shows up in the U.S. government’s budget as a receipt. Because most of the national government’s assets consist of uncertain future tax revenue, the government never compiles or reports a complete balance sheet for itself. In fact, future revenue is the only ultimate asset that backs up all the Treasury securities in the Fed’s portfolio. Consequently, the asset that corresponds to the Treasury’s “liability” of outstanding coins is never directly reported. But you can indirectly figure it out from the Fed’s H.4.1 release. The weekly release not only provides the consolidated balance sheet for the Federal Reserve System standing alone, but the release’s first section, “Factors Affecting Reserve Balances of Depository Institutions” has always combined the Fed’s balance sheet with the monetary accounts of the Treasury in order to present a full picture of all the factors affecting the monetary base.
This is why “Treasury currency outstanding” in that section of the release is a “factor supplying reserves” to the banking system. In effect, it is an “asset” in the combined monetary accounts. The vaults of the Fed hold a small amount of coin, which is therefore listed in the balance sheet for the Fed alone as an asset. But most Treasury coin is included with Federal Reserve notes as “Currency in circulation” as a “factor absorbing reserves,” or a “liability,” in the release’s combined monetary accounts. This total, which includes the vault cash of banks as well as cash held by the general public, is consequently always slightly larger than the liability “Federal Reserve notes” in the balance sheet for the Fed alone. The difference between the two is the estimated amount of coin being held by the public (minus the small amount of cash that the Treasury holds in the form of actual Federal Reserve notes, which is listed in the combined monetary accounts as another “factor absorbing reserves”). The net effect is that in the combined monetary accounts, most Treasury coin appears as both a liability in the hands of the general public and a fictive asset.
The reason this sounds complicated, if not totally abstruse, is because it is. Since the Fed was created, it has combined its own balance sheet with the monetary accounts of the Treasury in a confusing fashion, originally driven in part by the real-bills doctrine and genuine misunderstanding at the time about how the Fed affects the money stock. Milton Friedman and Anna Jacobson Schwartz sorted out these accounting obscurities in their Monetary History of the United States, 1867-1960, at the very end of Appendix B (pp. 797-98), where they show how to consolidate the Fed and Treasury balance sheets in a simple, straightforward fashion. For anyone interested in working through the intricacies of this part of the Fed’s H.4.1 Release, I highly recommend those passages in their classic work. But for our purposes, the important conclusion illustrated by Friedman and Schwartz is that the only actual asset backing up most of monetary base—whether it takes the form of Treasury coin, Federal Reserve notes, or commercial bank deposits at the Fed—is a “book entry to balance,” or as they put it more succinctly, “fiat.” And just as the Treasury can issue coins to cover government expenses without acquiring any asset of market value, so too can the Federal Reserve. After all, that is what fiat money is about.
Admittedly, pure fiat does not back up the entire monetary base. Both the Treasury and the Fed hold some genuine assets. For instance, the Fed still holds gold certificates, an asset of the Fed and liability of the Treasury, which in turn owns the actual gold at Fort Knox. The certificates are valued on the Fed’s balance sheet at the historical price of $42.22 on once. At current market prices, this asset would jump from $11 billion to around $340 billion, surely enough to cover a lot of Fed losses on other assets. I do not know whether the Fed could conduct such a revaluation entirely on its own authority or whether it would require the cooperation of the Treasury and Executive or even of Congress. But the ease with which this asset can be revalued, and the very fact that it does not show up in the Fed’s balance sheet at its current market value, underscores the ultimate irrelevance of Fed profits or losses.
In essence, the Fed functions—as do nearly all of the world’s central banks—like a giant legalized counterfeiter. It generates revenue the same way as any counterfeiter, by issuing money that imposes an implicit tax on the general public’s real cash balances. Therefore, it can no more be driven insolvent de facto than a successful, undetected, and illegal private counterfeiter. This is not to deny that Congress, having established the Federal Reserve System and the rules by which it operates, could decide that the Fed has somehow violated those rules and is nominally insolvent. But Congress can just as easily alter such rules to allow the Fed to continue operation. The future viability of the Fed, in short, is entirely a political decision, with absolutely no necessary economic relationship to any losses the Fed may suffer on its portfolio of assets.
Hat Tip: Less Antman, Warren Gibson, David Henderson, Bob Murphy, and Bill Woolsey.
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