The Fed Cannot Go Bankrupt, and That is a Big Problem

The Marriner S. Eccles Federal Reserve Board Building (commonly known as the Eccles Building or Federal Reserve Building)
AgnosticPreachersKid, CC BY-SA 3.0, via Wikimedia Commons

A recent essay on Mises Wire triggered quite a bit of discussion among a group of Austrian school economists. Paul H. Kupiec and Alex J. Pollock’s Who Owns Federal Reserve Losses and How Will They Impact Monetary Policy? became the focal point for a wide ranging discussion of monetary issues which got to the heart of our monetary and overall economic future.

The Fed Cannot Go Bankrupt

The article itself is a fairly straight forward explanation of how the Fed works and provides several options that the Fed might pursue in a rising interest rate environment. The authors contend that the Fed has intervened itself into a corner, where losses probably will increase as the Fed raises rates. David Howden opined that this might not happen, as the Fed will roll over its mostly short term, low yielding investments into higher earning assets, which will tend to protect its net interest income and provide an operating profit. Furthermore, the Fed has no requirement that it mark its low yielding investments to market. Were it required to do so, the Fed’s true financial weakness would be revealed.

The Fed Ignores the Rule of Law

But what can or will be done about it? Early in their essay Kupiec and Pollock conclude that nothing will be done, despite the provisions of the law creating the Fed over a hundred years ago. The losses will not go away; they simply will be transferred to the unwitting public through loss of dollar purchasing power. Per Kupiec and Pollock:

 “Innovations” in accounting policies adopted by the Federal Reserve Board in 2011 suggest that the Board intends to ignore the law and monetize Federal Reserve losses, thereby transferring them indirectly through inflation to anyone holding Federal Reserve notes, dollar denominated cash balances and fixed-rate assets.

The “innovation” in accounting policies centers around its newly penned “deferred asset” account to which underwater assets will be transferred. Per Kupiec and Pollock:

Today, the Federal Reserve Board’s official position is that, should it face operating losses, it would not reduce its book capital surplus, but instead would just create the money needed to meet operating expenses and offset the newly printed money by creating an imaginary “deferred asset” (Section 11.96) on its balance sheet.

If the Fed were subject to the rule of law, either it would have stopped money printing years ago, or it would have been forced to close its doors by its creditors. Yet, the rule of law is completely ignored. Per Kupiec and Pollock:

The Federal Reserve Board’s proposed treatment of system operating losses is wildly inconsistent with the treatment prescribed by the Federal Reserve Act.

The Keynesians running our economic life may be reassured that the Fed cannot fail in a technical sense, but the public should be appalled. The continual monetization of the federal budget threatens the complete loss of dollar purchasing power, to wit, a Weimar Republic-style catastrophe.

Unlawful Monetary Debasement Causes Capital Destruction

Today’s monetary leaders fail to understand the true nature of money and, thusly, cannot conceive that there are real consequences to their outlandish irresponsibility in monetizing government debt and brazen dismissal of the rule of law. As the facilitator of monetary debasement, borne by the general public, the Fed fosters the destruction of societal capital. The federal government does not have to answer to the law and the public for its irresponsible and destructive spending. The purpose of insolvency is to force an institution, whether public or private, to stop destroying capital. Austrian school economists understand that capital must be created by hard work, innovation, frugality, and most of all savings. Scarce capital is allocated by the market to those enterprises that create things of greater value than their scarce inputs.

The Solution is a “Return to Sound Money”

In 1953 Ludwig von Mises added a relatively short final chapter to his 1913 masterpiece The Theory of Money and Credit. Part IV, Chapter III is titled “The Return to Sound Money”. It is as relevant today as it was almost seventy years ago. Mises explains how the US, specifically, could anchor the dollar to its gold reserves. The Fed would be eliminated and replaced by little more than a board to monitor that all dollars are backed one hundred percent by gold. Mises was a master in presenting what self-serving Keynesian scholars try to hide in a fog of deception; i.e., that money can and should be subject to the rule of law as are all other economic goods in society. I daresay that there is no single reform that comes closer to fostering peace, freedom, and prosperity than a “return to sound money”.

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