On December 3, Congress passed a new highway and transit bill allocating $305 billion over the next five years. Part of the funding, allegedly $35.8 billion, will be taken from the Federal Reserve’s capital account. Further details on the maneuvering between the Senate and House versions, and Fed objections, are here, here, and here. Under the final compromise bill, about 8 percent of the Fed’s $35.8 billion contribution will involve a diversion of dividends from commercial banks, but the remainder is just a silly and deceptive gimmick for covering future federal expenditures. Both the banks and the Fed failed in their last-minute efforts to curtail these provisions during the debate over the omnibus spending bill that Congress passed last week.
To appreciate exactly what these provisions will do, we need to examine more closely the nature of the Fed’s capital account. The Fed is only nominally owned by its member banks, which comprise all nationally chartered banks and eligible state-chartered banks that choose to join. Member banks are required to hold an amount equal to 6 percent of their own capital and surplus in the “shares” of their respective district Federal Reserve Banks. Half of this amount is paid in; the other half is subject to call by the Fed’s Board of Governors. As member banks increase or decrease in size, their holdings must be adjusted accordingly. Obviously these “shares” are not like ordinary shares. They cannot be bought or sold on a secondary market, nor are they in any sense residual claims to the Fed’s earnings.
In exchange for these “shares,” member banks get a few limited privileges. Prior to 1980, the Fed’s check clearing and discount window was confined to member banks, but since then all banks and other depositories have access to both of these, with a market fee now imposed for check clearing. Member banks still get to choose six of the nine directors of their respective district Fed Banks, but only with severe constraints, which have gotten more severe with the passage of the Dodd-Frank Act. This gives banks some slight formal and circuitous influence over Fed policy.
But the main benefit of these “shares” is the dividend they pay, until now fixed by law at exactly 6 percent of the paid-in portion of a member bank’s capital. This is a bad deal for banks whenever inflation and nominal interest rates are high but a very good deal since the financial crisis. These “shares” therefore are financially more like debt than equity, in which member banks pass on funds to the Fed, which in turn buys Treasury securities (almost exclusively in the past) and now mortgage-backed securities. The member banks are in effect indirectly loaning money to the government in exchange for a fixed 6‑percent return.
The Senate version of the highway bill would have reduced the members dividends to 1.5 percent, with the remaining 4.5 percent payable by the Fed to the U.S. Treasury. When member banks unsurprisingly and strongly objected, the House struck out this provision to replace it with a second way of tapping into Fed capital explained below. The bill’s final compromise ties the dividend for member banks with more than $10 billion in assets to the interest rate on 10-year Treasury bonds, currently 2.2 percent, up to a maximum of 6 percent. This will release for payment to the Treasury an estimated $2.8 billion over the next five years. In essence, it constitutes a trivial reduction in the interest cost of government borrowing, annually about a quarter of a percent of the government’s current interest costs of over $200 billion (and this is net of existing Fed remittances to the Treasury).
This feature of the bill also makes more obvious the fact that the so-called “ownership” of the Fed by private banks is little more than a requirement to fund the Treasury. The reduced dividend over the long run may decrease the attractiveness of Fed membership for state-chartered banks. Given that the Fed power over non-member banks is now almost as extensive as over member banks, that hardly seems to matter much. The one attractive aspect of this way of funding is that, rather than increasing the total level of government spending, it merely redirects outlays from banks to transportation.
The paid-in portion of member bank “shares,” however, is only one of two components of the Fed’s capital account. The other component, labeled “surplus,” comprises residual Fed earnings from interest on its assets.[1] The House version of the bill, instead of diverting dividends, proposed employing this surplus capital, which today amounts to $29.3 billion, to cover new expenditures on highways and transit. Congress in the past has imposed levies on the Fed’s surplus, starting in 1933, when it took half to fill the coffers of the new Federal Deposit Insurance Corporation. In 1997 and again in 1998, Congress pulled out $100 million, and in 2000 it extracted $3.7 billion. Yet in each of these cases, the Fed replenished the surplus out of subsequent earnings. The House, in contrast, intended to empty the account permanently. The compromise version of the bill that passed both houses caps the Fed’s surplus capital at $10 million, with the remaining being passed to the Treasury, supposedly providing $33 billion of extra revenue over the next five years.
Until now, the Fed has almost always kept the value of surplus capital equal to the value of the other, paid-in component of the Fed’s capital, a mere reflection of that half of member bank “shares” that have not been paid in. Only briefly have Federal Reserve district banks ever drawn down their capital surplus, at least 158 times according to 2002 study by the General Accounting Office (since renamed the Government Accountability Office). This step was taken so as to absorb losses the Fed had incurred, mainly through its foreign-exchange operations, between 1989 to 2001.
But since the Fed creates money, the surplus capital is basically an accounting mirage. There is no idle pot of cash sitting in the account.[2] Any money that has been paid into the Fed — either through the sale of assets, through repayment of loans made by the Fed, or even through interest the Fed has earned on its assets — is not counted in the monetary base. When the receipts come from private banks or the general public, the money is withdrawn from circulation at the moment the Fed receives it, temporarily vanishing. Only if the Fed again pays out that money, does the monetary base go back up. Of course, much of it is immediately paid back out, as the Fed rolls over its asset portfolio or covers its operating expenses, so there is a constant flow of base money in out. Yet otherwise, these Fed receipts merely create an accounting entry on the Fed’s balance sheet labeled either as “accrued dividends and other liabilities” or “surplus capital.”
Much of the Fed’s revenue, however, comes not from the private sector but directly from the Treasury, as interest on the Fed’s portfolio of Treasury securities. Prior to the financial crisis, this was indeed the primary source of Fed income, but now it accounts for just a bit more than half of the total ($63 billion out of total earnings of $116 billion for calendar year 2014), with nearly all of the remainder from interest on mortgage-backed securities. The effect of these Treasury interest payments on the monetary base is a bit convoluted, but broadly it works out the same as for other Fed earnings. The difference is that the money has already been pulled out of circulation by the Treasury.[3] Still, when the Treasury initially pays interest to the Fed, the net amount not paid out again appears on the Fed’s balance sheet as “accrued dividends and other liabilities” or “surplus capital.”
In other words, the surplus capital is merely an entry on one side of the Fed’s balance sheet matching assets on the other side. To be sure, those assets do earn interest. So one way of thinking about the Fed’s surplus capital is that it permits the Fed to hold interest earning assets without increasing the monetary base. But after covering its expenses, the Fed remits most of its earnings to the Treasury on a monthly basis. (Out of $116 billion in Fed interest earnings from all sources during 2014, $97 billion was remitted to the Treasury.) Thus, to the extent that surplus capital increases the size of the Fed’s balance sheet, any additional earnings are ultimately funneled back to the Treasury already.[4]
With no actual money in the surplus capital account to begin with, the Fed can only reduce the account in one of three possible ways. The most straightforward would be for the Fed to create $19.3 billion of new base money for the Treasury to spend. In the first year, surplus capital would be run down to $10 billion, with $19.3 billion of Fed deposits and currency on the same side of the balance sheet ultimately replacing this fall in capital.[5] The total on each side of the balance sheet would remain unchanged. The Congressional Budget Office estimates that future increases in the capital of member banks will require the Fed to continue funneling between $2 and $3 billion of “surplus capital” per year to the Treasury. Because this method increases the money supply and is mildly inflationary, the Fed will more likely sterilize the transfer in two other ways discussed by Ben Bernanke in a blog post criticizing the House plan.
One of these alternatives would involve the Fed immediately selling off $19.3 billion of Treasury securities and transferring the proceeds from those sales to the Treasury. This would reduce the Fed’s total balance sheet on both sides by the same amount, but keep the monetary base roughly unchanged, sterilizing the transfer. But since the Treasury securities sold are now owned by the general public rather than the Fed, the Treasury no longer receives Fed remittances for the interest paid on this portion of its debt. What the Treasury has gained in one lump sum it now looses in the form of future income from the Fed, with the present value of both approximately the same. In short, with no new revenue or increased taxation, the Treasury’s new transportation expenditures will merely increase government deficits.
The Fed could instead cover its payment of $19.3 billion to the Treasury by directly reducing its regular Treasury remittances. In effect, the Fed would still only be giving back to the Treasury what it has first received from the Treasury in the form of interest payments. Again, the Treasury will lose approximately as much as it gains. Recall that in 2014, total Fed remittances to the Treasury came to $97 billion. So all the Fed would have to do is reclassify $19.3 billion of its future excess earnings as a payment from the surplus capital. To simultaneously reduce the surplus account to $10 billion without selling off any assets, all the Fed needs to do is move $19.3 billion into “other liabilities and accrued dividends.” Ceteris paribus, the balance sheet totals and the monetary base remains unchanged. The additional highway spending will still increase current and future budget deficits.
The Fed will probably use some judicious mix of all three methods to comply with the new requirement. Admittely, reducing the surplus capital from $19.3 to $10 billion also reduces the amount subject to call by the Fed Board from member banks. But since the Fed creates money, it has no need to exercise this call. This reduction in capital on call could decrease the extent to which the Fed can impose on bank shareholders any losses from a bank failure. Given how many other capital controls are placed on banks through the Fed, FDIC, and other federal agencies, it is hard to imagine that this will really have noticeable consequences.
In the final analysis, the only significant change for the Fed brought about by the highway bill is the adjustment in dividends paid to member banks, probably a desirable reform. The reduction in the Fed’s surplus capital, on the other hand, is an ineffectual cosmetic change, which the Fed can easily offset, raising the question of why Janet Yellen and other Fed officials have objected at all. The most insidious and misleading aspect of this attempted raid on the Fed is Congress’s ridiculous pretense that it will finance a spending hike without increasing taxes, increasing the deficit, or having the Fed print money. In reality, there are no other options.
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[1] Prior to January 1, 2011, the Fed’s capital account included a third component, labelled “other capital,” which consisted of additional Fed earnings that had not yet been remitted on a monthly basis to the Treasury or paid out as dividends. Since then, this component has been removed from the capital account and relabeled as “other liabilities and accrued dividends.” But in practice, it works out the same as the surplus capital, except its total value, which is much lower, is more volatile.
[2] There is one minor exception. The Fed does hold as an asset some Treasury created base money in the form of coins, currently about $1.9 billion.
[3] I’ve abbreviated what happens for clarity. Most tax and other payments from the public to the Treasury are initially deposited in tax and loan accounts at assorted depositories. Since these Treasury bank deposits are not counted in the broader monetary measures, tax payments reduce the total money stock, ceteris paribus, but have no initial impact on the base. Before the Treasury makes expenditures, it transfers these deposits from the banks to the Fed, sometimes within a day or less. At that point, these transfers do reduce the monetary base. On the Fed’s balance sheet, bank reserves fall by the amount by which Treasury deposits at the Fed go up. The exact reverse occurs when the Treasury makes expenditures, except for when it pays interest to the Fed.
[4] Milton Friedman and Anna Jacobson Schwartz were well aware of the quasi-fictitious nature of the Fed’s capital accounts when in Appendix B, “Proximate Determinants of the Nominal Stock of Money,” of A Monetary History of the United States, 1867–1960 (Princeton, NJ: Princeton University Press, 1963), pp. 797–798, they consolidated the Fed and Treasury monetary accounts by subtracting Fed capital from U.S. government securities on the asset side.
[5] Again I’ve abbreviated. Treasury deposits at the Fed will most likely go up with the initial fall in surplus capital, and the base will only increase as the Treasury draws down its deposits to spend the money.
