By Robert Eisenbeis, Ph.D.
One of the characteristics of a struggling republic is the inability to separate its central bank’s resources from the fiscal largesse of the federal government. Using central bank resources to avoid addressing funding of the government is a sure path to runaway inflation, economic decline, and periodic financial crisis. Take the example of Argentina, whose economy was the same size as that of the US at the turn of the century in 1900. Since then it has experienced repeated bouts of rapid inflation and crises both real and financial. Today, its GDP is about the same size as that of North Carolina, which is the US’s 9th largest state in terms of GDP. One of the problems Argentina faced was the ability of the federal government to finance expenditures by relying upon central bank assets. Indeed, “The central bank was lender of first resort to the treasury,” according to Alfonso Prat-Gay, who ran the central bank from 2002 to 2004.
Early on, the US Federal Reserve was a source of rediscount finance to support the agricultural cycle. During WWII, the Fed subordinated its balance sheet and independence to support the war effort, transferring funds to the Treasury and pegging Treasury rates. That policy culminated in the 1951 Accord, reestablishing the Fed’s position as an independent central bank. In 1996, Congress requested that the GAO study the Fed’s policy of maintaining its surplus account equal to its paid-in capital as of year-end the previous year. The purpose of the surplus accounts to provide a buffer against which losses could be recognized.1 Member banks are required by the Federal Reserve Act to subscribe to stock in the Federal Reserve Bank in the district in which the member banks are headquartered, and the subscription is to equal to 6% of their paid-in capital and surplus. Hence, the Fed can add to its paid-in capital only as member banks grow and not by issuing more stock.
The GAO study came on the heels of two raids of the Fed’s surplus initiated in the Omnibus Budget Reconciliation Act of 1993. That act, according to the GAO, directed any Reserve Bank whose surplus exceeded 3% of the paid-in capital and surplus of member banks in its district for fiscal years 1997 and 1998, to transfer those surplus funds to the Treasury. And the Reserve Banks making those transfers were not permitted by the Act to replenish their reserves during those two fiscal years.2
The table below shows the relationship between the Fed’s surplus and paid-in capital accounts since the GAO’s 2002 study. There have been some temporary deviations of the aggregate Federal Reserve Bank surplus from paid-in stock.
In 2006, for example, there was a temporary decline, but the Federal Reserve’s 2006 annual report indicated that this decline was attributed to adoption of FAS 158, which required a reduction in surplus of $1.849 billion and then required the sharp subsequent adjustment shown in the chart.3
Recently, Congress has repeatedly resorted to tapping the Fed’s balance sheet in an effort to fund pet projects, creating a dangerous precedent and threatening the Fed’s independence. The first nose under the tent occurred with the 2010 Dodd-Frank Act, which created the Consumer Financial Protection Bureau. Congress mandated the Fed to fund the new bureau rather than subjecting the agency to traditional financing through appropriations.4
Then in December 2015, Congress struck again and reduced the Fed’s surplus even further with passage of the $305 billion Highway and Transportation Funding Act of 2015. That Act expropriated about $19 billion of the Fed’s surplus and capped the amount in the Fed’s surplus account going forward to $10 billion. It further reduced the 6% dividend on Federal Reserve stock paid to member banks.5
There are two important facts to recognize about these actions. First, as the 2002 GAO report points out, transferring resources from the Federal Reserve creates the appearance of an increase in federal receipts because of the peculiarities of government accounting; but such transfers don’t actually increase government resources when viewed on a consolidated basis. Federal debt held by the public declines but, again, only because Federal Reserve Treasury holdings are considered debt held by the public, even though the Fed is a government entity (or at least the Board of Governors is).6 Viewed properly, all that is happening is an intra-governmental transfer of resources. Moreover, such a transfer reduces future remittance transfers from the Fed to the Treasury unless offset by additional asset purchases by the Fed.
Second, as a result of the financial crisis and expansion of the Fed’s balance sheet through its quantitative easing programs, the Fed’s leverage and loss absorption capacity has been radically reduced since its capital-to-asset ratio has declined to 0.9 percent, and we have estimated that an across-the-board 17 basis point increase in the term structure would be sufficient for the market value of Federal Reserve system assets to be less than the value of its liabilities.7 To make matters even worse, the two-year budget passed by Congress last week further expropriated another $2.5 billion of the Fed’s surplus, reducing it to $7.5 billion.
In the context of the budget and policies now in place, the $2.5 billion of surplus transfer is no more than rounding error, relative to the size of projected budget deficits, which could reach $1.2 trillion. But the risks to the Fed and its ability to carry out policies are now extremely limited when it comes to the ability to sell assets, if needed, as one way to reduce the size of its balance sheet. In particular, because the Fed carries securities on its books at par, any increase in interest rates would reduce the market value of its securities, which, if sold, would require recognition of those losses. The $7.5 billion surplus is clearly inadequate to absorb the potential losses. So the Fed will have to either forego assets sales or take advantage of an agreement struck by Chairman Bernanke with the Treasury, permitting the Fed to record losses in a negative asset account instead of booking losses against capital. Should a negative asset account become necessary, then remittances to the Treasury will cease until the negative asset account is extinguished.
As we have written previously, the optics of an insolvent Federal Reserve – even if it is of little substantive relevance since the Fed is backed by the Treasury and the resources of the United States – does not convey an image of strength and may not be well received in financial markets both domestic and (especially) foreign. Congress is serially weakening the Fed by tapping its resources, reducing its policy flexibility at just the wrong time and for no fiscally substantive reason.8 That practice is wrong and dangerous for our country. Let us not emulate struggling economies like many of those in Latin America.
1 Historically, such losses have typically been temporary and associated with foreign exchange transactions. The system has never had an annual loss, and Reserve Banks have recognized only temporary losses against their surplus accounts.
2 See GAO, Federal Reserve System: The Surplus Account, Report to Congressional Requesters, September 2002.
3 See Annual Report 2006, Board of Governors of the Federal Reserve System, pg. 128
4 The legality of the structure of that agency is under scrutiny by the Administration.
5 Small community banks were exempted.
6 Presumably, this treatment is due to the fact that the Reserve Banks are technically owned by member banks in their respective districts, and reserve bank employees are not considered federal employees.
7 See here
8 See Charles Plosser, “Argentina Redux,” July 2, 2016 for a former Federal Reserve Bank president’s concern about potential polarization of the Fed.