David R. Henderson  

Hummel on Fed Accounting

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Jeff Hummel has posted a careful analysis of the Federal Reserve's recent change in accounting rules. His bottom line is that basically the change is no big deal. Although Jeff makes the case very carefully, as is his wont, it does get a little complicated. I had to read it twice. But here's the final paragraph, for those who don't have the time, that sums up his case:

In essence, the Fed functions--as do nearly all of the world's central banks--like a giant legalized counterfeiter. It generates revenue the same way as any counterfeiter, by issuing money that imposes an implicit tax on the general public's real cash balances. Therefore, it can no more be driven insolvent de facto than a successful, undetected, and illegal private counterfeiter. This is not to deny that Congress, having established the Federal Reserve System and the rules by which it operates, could decide that the Fed has somehow violated those rules and is nominally insolvent. But Congress can just as easily alter such rules to allow the Fed to continue operation. The future viability of the Fed, in short, is entirely a political decision, with absolutely no necessary economic relationship to any losses the Fed may suffer on its portfolio of assets.

Here's an interesting paragraph that appears earlier in the piece:
Admittedly, pure fiat does not back up the entire monetary base. Both the Treasury and the Fed hold some genuine assets. For instance, the Fed still holds gold certificates, an asset of the Fed and liability of the Treasury, which in turn owns the actual gold at Fort Knox. The certificates are valued on the Fed's balance sheet at the historical price of $42.22 on once. At current market prices, this asset would jump from $11 billion to around $340 billion, surely enough to cover a lot of Fed losses on other assets. I do not know whether the Fed could conduct such a revaluation entirely on its own authority or whether it would require the cooperation of the Treasury and Executive or even of Congress. But the ease with which this asset can be revalued, and the very fact that it does not show up in the Fed's balance sheet at its current market value, underscores the ultimate irrelevance of Fed profits or losses.

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CATEGORIES: Monetary Policy

COMMENTS (3 to date)
Mike Sproul writes:

The Fed is not a counterfeiter. The Fed puts its name on its dollars, holds assets against those dollars, and stands ready to use those assets to buy back the dollars it has issued. No counterfeiter does that.

Prior to 1933, the fed would buy back its dollars with gold, bonds, or other assets like buildings, furniture, foreign currency, etc. Each of those items provided a channel through which Fed dollars could reflux to the Fed.

In 1933, the Fed closed ONE channel of reflux--the gold channel--while leaving all the others open. Dollars can still reflux to the Fed for bonds, buildings, furniture, etc., and if the Fed were ever liquidated, the Fed could, and probably would, use all of its assets to redeem all of the dollars held by the public.

joe cushing writes:

Mike sproul,

Let me see if I have this right. You take a green piece of paper to the fed and demand an asset in exchange. The fed hands you a white or brown piece of paper that says you are entitled to recieve--wait for it....wait for it--GREEN PIECES OF PAPER in the future. I feel so much better now that I know my green pieces of paper are backed up with real assets.

Mike Sproul writes:


A lot of those green paper dollars were issued in exchange for bonds in the first place, so it's not surprising that they can be retired in exchange for that same kind of bond. Of course, both the bonds and the dollars are acceptable by the government for tax payments, so the dollar is ultimately backed by the government's ability to take real resources from us in the form of taxes.

I sometimes issue money in the same way that the government does. I'm a landlord, and I sometimes buy groceries by writing out a paper "Mike dollar" that I accept for $1 of rent. I'm told that my Mike dollars sometimes pass through several hands before returning to me. They are backed by my rent collections in the same way that Fed dollars are backed by tax collections.

One of these days, I'll buy another rental house by issuing a $200,000 bond. If I then issue some more Mike dollars and use them to buy back a few dollars' worth of my bonds, then I'd be doing exactly what the Fed does when it buys US government bonds.

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