December 11, 2023 | Over the weekend, Bill Nelson, Chief Economist at Bank Policy Institute, put out an intriguing note (“Forward guidance: The Fed is probably solvent”) that argues that the central bank still has positive net worth despite its substantial operating losses. Nelson concludes:
“So before taking into account the value of seigniorage, the Fed’s economic value is $1 trillion ($6.7 trillion minus $5.7 trillion). If currency plus the TGA is expected to grow, as it always has before, the value of seigniorage is positive and the Fed is definitely solvent. For example, assuming a discount rate of 4.5 percent (the 10-year Treasury rate), if currency plus TGA is expected to grow at 3.8 percent per year (the FOMC’s outlook for nominal GDP growth in the long-run), the value of seigniorage is $15.9 trillion. But if currency is expected to shrink 2.5 percent per year, the value of seigniorage is -$1.05 trillion, the economic value of the Fed is negative, the Fed is insolvent.”
Our view of the Fed is that it is merely the alter-ego of the U.S. Treasury, a convenient canard whereby an additional layer of leverage was added to the American economy on the eve of WWI in 1913. A liability of the taxpayer is treated as an asset on the books of the central bank, which was not even allowed to own government debt at inception. The Fed was focused entirely on financing the private sector. So is the solvency of the central bank an important issue for public policy? Not really. It is part of the growing insolvency of the U.S. Treasury.
The assets and liabilities of the central bank, net of private equity contributions of member banks, ultimately belong to the United States, just as with all of the parastatal creations of Congress. And for this reason, the Fed can never actually show a profit in a true economic sense and is always an expense to the taxpayer. As a result, the only truly relevant fiscal question when it comes to the Federal Reserve System is how much of an expense does the central bank represent?
Nelson and other former employees of the Fed, ourselves included, have long fretted over the growing operational and financial stress visible at the central bank. As we opined last week with a chart published by the Federal Reserve Bank of St Louis (FRED), the deviation in financial performance by the central bank is extraordinary and begs the question as to why nobody in Congress has asked Fed Chairman Jerome Powell for an explanation. The chart below shows historical “remittances” from the Fed back to the Treasury.
While Nelson and other researchers like to pretend that the Fed is a separate institution independent from the U.S. government, in fact the central bank lost its prized independence more than half a century ago. In 1966, when Congress “allowed” the central bank to purchase debt from agencies that are owned or guaranteed by the federal government, the central bank lost any real independence and became a captive funding vehicle for the Treasury.
Many economists, of course, have trouble accepting the reality of the fiscal relationship between the Fed and the Treasury. Nelson notes a paper published by Federal Reserve System Staff in 2016 – “Fiscal Implications of the Size and Composition of the Central Bank’s Balance Sheet,” which largely supports the idea of separateness and also solvency.
Fed staffers Bi, Cavallo, Del Negro, Frame, Malin, and Rosa (2016) observe that a central bank is solvent if the market value of its assets minus the market value of its interest-bearing liabilities plus the expected present discounted value of future seigniorage is positive. Put another way, the central bank is solvent if the expected present value of its "profits" is positive.
Nelson relies upon two main factors to support the idea that the Fed is solvent. First, the natural inflation of the currency and second, the likewise inflating value of seigniorage (the monopoly on providing the public with currency). We tend to discount these arguments, however, because ultimately the legal tender monopoly of the greenback that goes back to the Civil War belongs to the Treasury itself and not its instrumentalities. Consider an example.
“In August 1861, a couple of weeks after the Union’s disastrous defeat at Bull Run, Treasury Secretary Salmon P. Chase traveled from Washington to New York in search of money,” writes Nicholas Guyatt in a wonderful review in the NY Review of Books (“Blues, Grays & Greenbacks”). At the time, there was no central bank and the nation’s paper currency was issued by private state-chartered banks, with paper money backed by gold. Any potential for seigniorage related to public money obviously belonged to the Treasury.
When Chase demanded that the largest banks lend the Treasury all of their gold, the banks naturally refused. This led Chase to eventually decide to issue unbacked paper money, “greenbacks,” to finance the war. If the bankers in Boston, New York and Philadelphia refused his request for financing, said Chase: “I will go back to Washington, and issue notes for circulation; for it is certain that the war must go on until the rebellion is put down, if we have to put out paper until it takes a thousand dollars to buy a breakfast.”
As we noted in "Inflated: How Money & Debt Built the American Dream (2010)," Treasury Secretary Chase’s famous gambit to finance the Civil War with fiat money ultimately succeeded and in the process made the US stronger financially. The natural growth of the economy and insatiable demand for currency inflated the value of greenbacks back to parity with gold, this after paper lost much of its value during the conflict.
The difference, of course, is that the audacious actions of Chase to finance the Civil War without borrowing gold from the banks helped grow the value of the US economy. The US had little debt in 1865 and even the float represented by greenbacks was quickly absorbed.
The more recent experience with quantitative easing and fiscal largesse from Congress in the wake of COVID, however, begs the question asked by Nelson about the “value” of the Fed in a deflationary environment. If the value of the Fed's esatz assets falls instead of inflates, then the central bank is insolvent using Nelson's methodology.
Fortunately, the dire prediction made by Secretary Chase about paying $1,000 for breakfast has not yet arrived. Ultimately, the real question facing the Fed and the economist community is not whether the Fed is broke or whether the FOMC can get inflation back down to the 2% target, but rather whether the central bank can keep asset prices growing indefinitely. As the deflationary pressure of tens of trillions in public debt relentlessly pushes us toward a general deflation event, possibly led by a home price correction later in the decade, the Fed’s job remains promoting inflation.
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