Tuesday, February 22, 2011

The Federal Reserve - Frequently Unanswered Questions (rev. 02/11)

Who owns the Federal Reserve?

The Fed website states, “The Federal Reserve System is not "owned" by anyone and is not a private, profit-making institution. Instead, it is an independent entity within the government, having both public purposes and private aspects.”

Apparently finding this answer unsatisfying, others have pointed out that each Federal Reserve member bank owns stock in the Fed equal to 3% of its capital. However that answer, too, doesn't really clarify things much, and this ownership is quite restricted, since these shares cannot be sold, traded, or pledged as security.

Examining the Fed's balance sheet, however, one finds that the majority of its liabilities are banking system reserves, owed to the member banks. It therefore seems reasonable to assume that these member banks have a priority claim against the Fed's assets. And since bank reserves exist to protect depositors, as well as US taxpayers in the event of insolvency, the Fed functions as a sort of fiduciary trust, the beneficial interest in which belongs to the public.

If the Fed isn't a government agency, how are its operations paid for?

Most of the Fed's income comes from interest on government debt that it holds. It also collects fees for operational services it provides, like check clearing for the banking system. Any extra earnings are paid back to the US Treasury.

The Fed has been buying more treasury debt lately under these programs referred to as “quantitative easing”; how much treasury debt does it own now?

As of February 2011, the Fed's balance sheet shows it owns about $1.2 trillion in treasury debt. This is about 9% of the total outstanding public debt of $14.1 trillion. By the end of the current QEII activities in June, the Fed should own about $1.6 trillion in treasury debt, or about 11% of the outstanding public debt in the US.

How do these amounts compare to other metrics, just to provide a bit more perspective?

Well, Neil Barofsky, Special Inspector General for the government's Troubled Asset Relief Program, stated last July that TARP could cost US taxpayers an estimated $23.7 trillion. GDP in the US is about the same as the national debt, around $14 trillion. President Obama's proposed 2012 budget, released in February 2011, totals about $3.8 trillion dollars, with a projected annual deficit of around $1.1 trillion; the budget deficit for 2011 is estimated to be $1.645 trillion. So, by comparison with other “federal numbers,” the Fed's holdings of treasury debt don't seem particularly large.

However, on the other hand, we've been hearing lately that a lot of states are in financial trouble. Collectively, the 44 states with budget problems, plus the District of Columbia, are facing a total budget shortage of about $250 billion. So if the Fed were to sell just 20% of its treasury holdings, it could balance every state budget across the entire county, at least until next year.

Where does the Fed get the money to buy these treasury securities and expand its balance sheet, like we're seeing now?

When the Fed purchases treasury debt, it does so through one of its so-called primary dealers. The primary dealers are large banks and brokerage firms that work with the Fed and the treasury, assisting with treasury auctions and with the Fed's open market operations, among other things. When the Fed buys treasury securities from one of these primary dealers, payment is made by electronic credit to the dealer's reserve account with the Fed. This credit represents new money added to the system.

In other words, the Fed simply creates new money to buy treasury debt electronically?

That's correct.

And the treasury securities now appear as assets on the Fed's balance sheet, with a corresponding deposit to the dealer's reserve account appearing as the offsetting liability?

That's also correct.

Something about that sounds … well, kind of bogus.

Let's speak clearly here. It's no more bogus than the ancient Romans' “clipping” of gold solidus and silver siliqua coins, or the way the government of Zimbabwe printed more currency a few years ago to pay for things. These things really happen, and with some frequency, as history shows. It is the process of increasing the supply of money, and adding liquidity. The results can be disastrous, if there isn't some restraint to the process. The Fed is the entity that is supposed to provide that restraint, and was designed to hopefully prevent the kinds of abuses in those other examples.

Explain the other side of the equation, the deposit to the primary dealer's reserve account. What's that all about? And what are reserves, anyway?

In the US, we have what's called a fractional reserve banking system. The idea is that, to reduce the risk to depositors that a bank won't be able to give them back the money they have on deposit, whether it's because the bank made too many bad loans or some other reason, the bank isn't permitted to lend out all the money it has. The requirement is that a bank can only lend 90% of the money it has on deposit; the remaining 10% is held as a reserve.

It is of course much more complicated than that, but that's the idea, in a nutshell. The total of all bank reserves is tracked by the Federal Reserve, and is accounted for essentially like it is on deposit with the Fed.

Now, regarding these purchases of treasury debt where the Fed is creating new money:

Since the Fed was intended to operate somewhat more responsibly than did the ancient Roman emperors and the heads of banana republics, it adheres to the modern conventions of double entry accounting: i.e. it keeps a balance sheet. And when it buys an asset – even when it creates new, electronically-coined money to pay for it – that asset becomes, essentially, collateral and security to guarantee the safety of money on deposit in the banking system. In other words, the entire value it represents becomes part of the reserve base. This is achieved, accounting-wise, when the Fed pays for securities by making a credit directly into the reserve account, held at a Federal Reserve branch, of the primary dealer selling the securities.

As you can see, this is different from the government simply printing money and spending it, because there are now treasury securities purchased with this new money that are held by the Fed in reserve for the benefit of bank depositors and the public.

So, if I buy a treasury bill through my broker and they deposit my check in their bank, only 10% of the deposit is counted as bank reserves. But when the Fed pays a primary dealer, it all becomes reserves. Can you elaborate on this a bit? And what are the consequences of this?

There's endless debate related to this subject, and there doesn't seem to be any definitive answer. It seems logical there are specific regulations and operational requirements regarding the handling and subsequent use of these reserve funds by the primary dealers, but there doesn't seem to be much public transparency on the issue (see note, below.)

However it's obvious that this provides additional liquidity to the system, not only due to the Fed's demand for treasury debt, but because adding reserves to the system frees up funds for the banks to use. Many of these primary dealers that the Fed works with also have commercial banking and brokerage operations, and trade in the equity, currency, and other markets on their own behalf. So boosting their reserve accounts like this is a form of leverage, freeing up significant funds.

It's very important to recognize here that the Fed's primary dealers are being given a special, fiduciary trust. Clearly you wouldn't want to increase the reserves of just any private financial institution, because there's great potential here for abuse. Essentially, the strict 10% reserve requirement on deposits is being relaxed for these institutions, and if their practices become too aggressive or irresponsible, it's like you've handed a loaded gun to a criminal, giving them additional reserves.

(Note: Those interested in pursuing this further may wish to begin by researching the Treasury's Supplemental Financing Program (SFP) initiated in September, 2008, purportedly to assist the Fed in managing its balance sheet and complexities of its adding liquidity to the financial system, originally in response to the failure of Lehman Brothers and the so-called financial crisis. Of course the Fed's balance sheet has ballooned tremendously since then, and not surprisingly, the SFP has been extended. While the SFP was originally represented to be primarily intended as a facility for draining excess reserves out of the system, presumably in anticipation of the added liquidity providing much quicker and effective stimulus than was actually seen, it appears that actual management of the SFP recently has been such that excess reserve balances are being maintained at high levels. Given that loan demand remains quite slack, one must question what is the true purpose behind all this reserve creation we're seeing today.)

Who are these primary dealers, anyway?

There are 18 of them, some probably everyone's heard of, like Goldman Sachs, JP Morgan, and Citigroup. For the most part, it's the big investment banks.

Wait a minute! You mean, some of the biggest campaign contributors from the last election, the guys who probably benefited most from TARP and the bank bailout, even though they caused the financial crisis?

Well, many people do see it that way, and believe the reason they are “TBTF” – Too Big To Fail – is because of their political influence.

But you can also make a persuasive argument that many ordinary Americans would have been negatively impacted, if not for the actions of the government and the Fed to assist these big financial firms. Perhaps the most obvious is that the typical American household relies heavily on credit, and the TBTF's are major providers. Citi is a huge credit card issuer, as is Chase, which is owned by JP Morgan. They're also major players in the mortgage industry, at various levels. Sure, the housing market has struggled, but almost certainly would be in far worse shape if not for the intervention of the government and the Fed.

More generally, many Americans have benefited from the economic stimulus this activity provides. Not only does the Fed encourage lower interest rates by creating demand for treasury debt (they also buy mortgage debt, with similar effect) but increasing reserves promotes lower rates as well, while making capital available for investment. As of mid-late February, 2011, the US stock market, as measured by the S&P 500, is up more than 30% since last July, and has doubled from its lows of March 2009. There can be little doubt that the proprietary trading activities of the big investment banks, along with funding they provide that enables other investment, has had a lot to do with that. If you own a 401k, or an IRA, or just have personal investments, your net worth is most likely higher today as a result of the bailout of the TBTF's than it would be otherwise.

But you said that “primary dealers are being given a special, fiduciary trust” and that “you wouldn't want to increase the reserves of just any private financial institution.” I'm seeing a huge disconnect and a real problem....

If there's a question here, I'm guessing it's asking for an opinion about some of the primary dealers, how responsibly they're run, and if they haven't used their size and influence to receive preferential treatment. And again, many people do see it that way, that some of these firms should not be trusted. That's beyond the scope of this FUQ, which is intended primarily to clarify some things about the Fed. Then, perhaps, the answers to questions like this will become more apparent.

This seems incredibly complex, this interrelationship between the government and the treasury, the Fed, and the primary dealers who are also the largest banks and brokerages in the world. Who designed such a system?

It's vastly more complex than this broad overview even begins to suggest. The Federal Reserve was created by congress in 1913, and clearly, no one at that time envisioned anything like the quantitative easing the Fed is engaged in now, or the extensive relationship with the private financial sector. The Fed's function has expanded and evolved over the years, and it has proven to be very adaptable.

I don't know, though; a lot of this seems a little fishy, or just doesn't make sense. For example, you've said that the treasury securities the Fed owns are a kind of security or collateral to protect bank depositors and the public. But the public, the depositors, are the taxpayers. What's the point of holding a debt that we owe as security for something that's just another liability to us – an IOU written to ourselves?

You have a point. But the dilemma is this: Obviously, you want the Fed to manage and invest reserves in the banking system in a very safe and responsible fashion. When the Fed was organized nearly 100 years ago, the US was on a gold standard, and the country had significant gold reserves. Gold was almost universally accepted as a store and reference of value. Yet as we all know, the US went off the gold standard in 1971. Since then, US treasury securities have come to be viewed as the safest, most conservative, highly liquid instruments available. So, practically speaking, of the different investments the Fed might make, treasury debt has to be considered the safest.

In other words, under the present system, the best way to assure that funds are available to protect the public in the event of bank defaults and insolvency is to hold public debt as a sort of insurance policy, guaranteeing payment.

Plus you might even argue, as an added bonus, the way the Fed is set up more or less forces it to add safe, treasury-secured reserves to the system when it engages in activities such as the quantitative easing we're seeing now – activities which themselves pose risks to the banking system.

OK, but with the debt problem in this country, why have the Fed own treasury debt that's paying interest? Surely if the Fed can create money to buy treasuries, it can create money to pay them off. Then create an interest-free, contingent liability backed by the government to backstop the banking system if there are problems. That wouldn't cost the public anything until it's needed, if it's even needed at all. What's wrong with that?

There are several problems with that idea:
  1. By being a buyer of treasury debt, the Fed is helping keep rates down, which lowers the cost of financing on all treasury debt.
  2. As stated earlier, the Fed pays for its operations with the interest it earns on securities, with any excess interest income paid back to the Treasury. Unless you were to also cut the Fed's expenses, there would be no savings realized by the Fed's not owning treasury debt.
  3. As also discussed, above, the Fed's buying and owning of treasury debt is a necessary component of its present operations. Without extensively redesigning and restructuring the Fed, forbidding it from owning treasuries would severely limit its ability to control interest rates, inflation, the money supply and the economy in general. Providing economic stimulus during recessions, or cooling off an overheating economy, would be more difficult.
  4. In terms of reducing the public debt, paying off or retiring what's owned by the Fed really wouldn't accomplish much. The budget deficit for 2011 alone is greater than the value of the treasuries the Fed holds, and is but a fraction of what further deficit spending in the years ahead is almost certain to add to the national debt.
There's still something about this whole thing that seems wrong. The answers given hear seem sensible, yet you sound like some kind of apologist, even a defender of the Fed and what it's doing. Why do I still have the feeling there's something very corrupt in this, that it mostly just serves the interests of the powerful and the wealthy?

Why do you feel that way? Probably because there is indeed something very corrupt going on here. If I've sounded like a champion of the Fed, of what it and the other involved parties are doing, it's only because I have tried to answer the questions here as objectively as possible, describing how the Fed functions, while leaving out my own opinions.

But since this has been asked, the real problem isn't in the way the Fed is structured, although clearly, better balances and controls are needed. Rather, like any human organization, it will inevitably become corrupt if the people in control are corrupt. So that's the problem, and you can no more fix that through legislation or fiat than you can change human nature.

That's hardly an answer. You've obviously given this some thought, preparing this FUQ, so why won't you tell us what you think? Are you saying that the people at the Fed are corrupt, Bernanke and the Fed governors?

Fair enough.

Honestly, when I started doing research for this little Q&A piece, I expected to find something seriously flawed with the Fed, its design, operation, or those who run it; perhaps all three. Having a finance background myself, I've had opinions about these things for a long time, and in recent years I had come to think pretty poorly of the Fed. I even decided to call it my “Fed FUQ” before I really understood everything presented here, thinking that was an appropriate play on words. I've only kept the name, hoping it will incline a few more people to read it.

As I came to understand the Fed better, my opinion changed. I think the Fed is designed and structured very intelligently, with the capability to not only be a sound fiduciary and overseer of the banking and financial system, but a responsible instrument for directing monetary and economic policy, if used wisely. You've read the comments and explanations, above, and I feel they highlight some of the Fed's strengths. It is so clearly a better approach to accomplishing its intended purpose than any of the others we've seen in the past, I don't think there can be much debate on that point.

Of course the Fed isn't perfect, and if it suffers from any truly serious flaw, it is the fact that the Fed Chairman is a political appointee (the seven Fed governors are also appointees; arguably their 14 year terms insulate them from political pressure, but with both major political parties receiving massive donations from Wall Street today, politics no doubt enters in there as well.) On this my opinion did not change while working on this Q&A; indeed, it is now even more deeply entrenched.

Chairman Greenspan took the Fed, and so our nation, down a reckless course, starting no later than the late 1990's when the central bank routinely began using its liquidity facilities in response to problems in overseas markets, as well as those at home. The manifold problems we see in the economy and financial markets today are, in large measure, a result of overly accommodative interest rate policy for far too many years, combined with efforts to influence asset prices in the past decade.

This lack of restraint, which continues under current chair Bernanke, was heartily embraced by a burgeoning financial industry, which today wields extraordinary influence over Washington politics. Thus the Fed finds itself engulfed between the powerful interests of Wall Street, and the federal administration and congress which those interests effectively control. When President Obama made Larry Summers director of the National Economic Counsel and appointed Tim Geithner Treasury Secretary, it should have been obvious to all that the fix was in, and the succession of Wall Street influence in Washington that began with Robert Rubin – named Clinton's treasury secretary after a 26 year career at Goldman Sachs – would continue.

It is not a new idea, that money and power corrupt. It is as old as our history, and a part of human nature. This is simply another example, another chapter.