Treasury’s $1 Trillion Coin and the Fed’s Magic Asset

Supposedly, just like that, all our money problems would then disappear.

In 2019, my colleague George Selgin pointed out nothing in the law would require the Fed to go along with this gimmick, and it would be unlikely people working at the Fed would take part in such a scheme. This week, Treasury Secretary Janet Yellen essentially made the same point, telling reporters:

But given one of the coin’s staunchest advocates likens the Fed’s potential refusal to go along with the scheme to the constitutional crisis faced by Abraham Lincoln and wants President Biden to “send troops to the Fed” if it refuses to accept the coin, it’s unlikely the $1 trillion coin idea will take its proper place in the annals of history anytime soon.

Besides, many proponents of the $1 trillion coin are also some of the staunchest supporters of modern monetary theory, the idea widely referred to as MMT. The logic behind both ideas is pretty much the same: pretend physical resources exist in unlimited quantities and we really can get something for nothing.

As many economists have pointed out, there is nothing modern about MMT, and it really isn’t much of theory. As Selgin puts it, “MMT often boils down to nothing more than an especially naïve sort of Keynesianism: assume an unlimited excess supply of every resource save money balances, and, voila! monetary expansion can costlessly finance all the projects we like!” (For a formal critique, see Thomas Palley’s paper.)

While the $1 trillion coin idea hasn’t really gained traction, the same can’t be said for MMT. Advocates of massive government spending programs ranging from the Green New Deal to a National Infrastructure Bank often appeal to MMT.

Regardless, the coin idea is analogous to 15^th century European monarchs devaluing all the coins in the kingdom. But just as back then, even if we give the Treasury several $10 trillion coins, it won’t change the quantity of real resources available. People would simply bid prices higher and, in the end, be no better off.

And if the rest of the world views our newfound extravagance as something from a 15^th century monarch-slash-banana republic — as it should — Americans will be worse off.

As ridiculous as this $1 trillion coin might seem, it’s not nearly as scary as something else the Fed takes very seriously, a procedure based on similar economic logic. Specifically, it’s an accounting gimmick known as the magic asset.

As first described by Ben Bernanke, the Fed could prevent a government default simply by expanding this magic asset, a balance sheet gimmick that it started using in 2010. (See p. 21 of the Fed’s annual statement.) Since that time, the Fed has stated that if it does not earn enough to cover its annual operating costs, it will create a deferred asset rather than report negative equity. The Fed states:

The deferred asset is the magic asset. Though like a tax loss carry forward, the “amount of net earnings a Reserve Bank will need to realize before remittances to Treasury resume” is entirely up to the Fed. (The Fed does not follow generally accepted accounting principles (GAAP), it follows the Financial Accounting Manual for Federal Reserve Banks, a set of accounting principles the Fed created.)

The implication, of course, is that there will be earnings in the future and the Fed will remit those earnings to the Treasury. So, the Fed could just decide that it will hold back from Treasury an additional amount in the future and increase the deferred asset.

The Fed could, for instance, decide that it will hold back an additional $1 trillion in the future and increase the deferred asset now by $1 trillion. As the deferred asset goes up, capital goes up by a corresponding amount.

Just as it did in 2015, Congress could then raid the Fed’s capital account. Back then, they raided the Fed to pay for new highway spending. But there is no reason that Congress couldn’t now take the Fed’s capital surplus to pay for whatever Congress wants. (For what it’s worth, I mentioned back then Congress was setting a dangerous precedent.)

Still don’t think this gimmick sounds crazy?

In a 2016 Brookings blog post, Ben Bernanke himself explained that the Fed could use this method to create helicopter money to stimulate the economy. As he pointed out, the move would give Treasury money to finance a tax cut without raising the federal debt. The Fed would essentially turn over to Treasury an amount of money that represents the present value of future seigniorage.

Bernanke was concerned with the Fed’s ability to provide stimulus when interest rates were at zero, but Treasury and Congress could use the very same method to avoid a default.

Of course, this scheme would set a precedent far worse than the 2015 highway raid, and Congress would be tempted to do it again all the time. Nonetheless, it’s easy to envision members of Congress arguing the alternative to this special helicopter drop would be for the United States to default on its debt, possibly causing a global recession that destroys the dollar’s hegemony.

Does the gimmick sound less crazy yet?

Here’s another fun fact: Under the Fed’s current operating framework (a floor system), after the Treasury spends all this gimmick money, it would end up as reserve balances kept in check by interest payments on those reserves. That is, unlike under the Fed’s old (scarce reserve) operating framework, those reserve balances would not automatically be inflationary.

Formally, the Fed’s new operating framework divorces its balance sheet from its monetary policy stance. The Fed can buy assets (or create reserves by way of the magic asset approach) and maintain a tight policy stance by preventing those reserves from expanding the broader monetary aggregates. To accomplish this feat, the Fed would simply pay banks to hold those reserves.

As I – and George Selgin – have pointed out before, the framework removes an important tool the Fed used to have to maintain its operational independence. Now, however, the Fed can no longer legitimately tell Congress “No, we can’t buy those assets because it will cause too much inflation.”

Put differently, the Fed has opened the door to becoming a piggy bank for excessive federal spending.

The Fed has also opened itself up to a new political problem because as those reserves pile up and interest rates rise, the Fed pays billions of dollars in interest payments to large banks, reducing the money the Fed remits to the Treasury. Because of the existing reserve/​interest rate situation, the Fed has been losing about $2 billion a week since mid-September.

It hasn’t had an annual loss yet, but it may have one in 2023, triggering its use of the magic asset. (Table 6 on the Fed’s H.4.1 release shows the Fed currently books these losses by making more negative the liability “Earnings remittances due to the U.S. Treasury.” For more on Fed losses, which could result in Treasury remittances being suspended until 2028, see this Mercatus Center Policy Brief, this NBER working paper, or this Hoover Institution working paper.)

The Fed has the power to insulate itself from this kind of shenanigans by returning to a scarce reserve operating framework — the type of system it operated prior to the 2008 financial crisis. If it doesn’t, it’s only a matter of time before it will no longer be able to resist political pressure to buy more federal debt and fund more federal spending.

The 118^th Congress should make fixing this problem a top priority.