Sheet?

Chapter 7

Would Stimulus without Debt Weaken the Fed’s Balance Sheet?

At first glance it might seem that stimulus without debt would cause the Fed to have a balance-sheet problem. Why? When the Fed buys a Treasury bond in the open market, it obtains an asset, but if the Fed gives the Treasury a transfer, it obtains no asset. On the Fed’s balance sheet, the Fed’s “capital” (“net worth”), defined as assets minus liabilities, would therefore be reduced by the amount of the transfer if the Fed gives a transfer instead of buying Treasury bonds.

But the Fed can avoid a balance-sheet problem by taking the following action. Just before the Fed writes its transfer check to the Treasury, the Fed should order an amount of new Federal Reserve notes (from the usual place, the Treasury’s Bureau of Engraving and Printing) equal to its transfer to the Treasury and then store these notes in the Fed’s vault. Cash in the Fed’s vault is an asset on the Fed’s balance sheet, so the Fed’s total assets would increase by an amount equal to the Fed’s transfer to the Treasury—the same increase in total assets that would have occurred if the Fed had instead spent the same amount of money buying Treasury bonds. Moreover, just as Treasury bonds

held by the Fed are not used to meet requests by banks or the public for Fed notes, neither should these new notes in the Fed’s vault; requests for Fed notes should be met as usual by ordering additional new Fed notes, just as if the vault contained Treasury bonds instead of Fed notes. With this ordering and storing of Fed notes in the Fed’s vault, stimulus without debt would not reduce the Fed’s capital, just as the Fed’s purchase of Treasury bonds does not reduce the Fed’s capital.

For example, suppose the Fed plans to transfer $450 billion to the Treasury for fiscal stimulus in a severe recession and Congress enacts a $450 billion fiscal stimulus. Just before making the transfer, the Fed would order $450 billion in new Fed notes from the Treasury’s Bureau of Engraving and Printing, and upon receiving these notes the Fed would store them in its vault. To simplify, suppose the $450 billion fiscal stimulus consists entirely of tax rebate checks to households and that the households deposit these checks at their banks and request $450 billion of Fed notes. Under current balance-sheet accounting for the Fed, the $450 billion of Fed notes held by the public would be listed on the Fed’s balance sheet as a liability, but this Fed liability would be matched by $450 billion of new Fed assets—new Fed notes in the Fed’s vault—so there would be no change in the Fed’s capital. If the banks request only $50 billion of Fed notes (instead of $450 billion) and increase their deposits at the Fed by $400 billion, once again Fed liabilities increase $450 billion ($50 billion plus $400 billion), so once again there would be no change in the Fed’s capital.

By contrast, if a firm or household writes a transfer check to someone, its net worth decreases by the amount of the transfer check, and the firm or household is not able to order and store new Federal Reserve notes to prevent a decrease in its net worth. But the Fed can. That’s exactly the point. Congress has given the Fed, the central bank of the United States, the power to order

new Federal Reserve notes, while Congress prohibits firms or households from doing the same. Moreover, the Fed does not have to “back” Federal Reserve notes with gold or anything else.

My recommendation illuminates the fundamental point that the Fed has the power to raise its total assets promptly by as much as it deems necessary. Thus, the Fed can always make sure its assets exceed its liabilities; it can always make sure its net worth is positive.

This chapter could end here because the ordering and storing of new Fed notes solves the balance-sheet problem without any change in the current balance-sheet accounting used by the Fed. But it is worth looking further into whether the current balancesheet accounting used by the Fed should be reformed, and if so, to make sure that stimulus without debt still would not reduce the capital (net worth) of the central bank.

Should the Fed’s Accounting Be Reformed?

There are two fundamental reasons why the current balancesheet used by the Fed should be reformed: (1) its overstatement of the Fed’s total liabilities; (2) it failure to recognize that the Fed has the power to promptly raise its total assets. After explaining these two problems, I recommend a reform of the Fed’s current balance-sheet accounting.

Overstatement of the Fed’s Total Liabilities

On the current balance sheet of the Federal Reserve, the item “Federal Reserve notes held by the public” (including banks) is listed as a liability. This is consistent with the view held by some that government paper money held by the public is government debt, just like Treasury bonds held by the public.

Recall, however, that in chapters 2 and 3 I explained why paper money held by the public is not government debt. Listing paper money as a liability on the Fed’s balance sheet made sense when the Fed pledged to pay gold to anyone presenting Fed notes and requesting gold. The Fed had to worry about whether it could always obtain enough gold to fulfill its promise if a panic should sweep holders of Fed notes, who might create a “run” on the Federal Reserve by demanding gold in exchange for their Fed notes. But for many decades, the Fed has not pledged to pay gold or anything else to anyone presenting Fed notes. Hence, Fed notes held by the public are no longer a Fed liability because the Fed doesn’t owe anything to holders of the notes. It follows that Fed notes held by the public should not be listed as a liability on the Fed’s balance sheet.

Some background is useful to appreciate why Fed notes in circulation should not be counted as a liability of the Fed on its balance sheet and to grasp the significance of the fiat money system most countries have today. In their macroeconomics textbook, Sachs and Larrain (1993) give an insightful explanation of the central bank’s balance sheet under fiat money that supports not counting Fed notes held by the public as a liability of the Fed. They begin by pointing out that official government paper money is “legal tender,” which means that a creditor must accept government paper money from a debtor, and that taxes are paid with government paper money (or a bank check backed by government paper money).

They then explain how fiat money evolved. When government paper money was first introduced in the past two centuries, the government pledged to provide ounces of gold or silver to any holder of paper money who requested it. But once the public became confident about the paper money after many years of use, the government withdrew its pledge. Yet even without a government pledge to provide gold or silver, the paper money continued

to be used. Paper money unbacked by gold or silver is called fiat money. Fiat money has been widely used only in the twentieth century. Today virtually all countries use fiat money.

In a system dependent on gold or silver, the economy was buffeted by either new discoveries or the absence of new discoveries of gold and silver. New discoveries enabled governments to expand paper money, and the economy experienced an inflationary boom. Absence of new discoveries prevented governments from increasing paper money as fast as potential real output and the economy experienced a deflationary bust. An economy that depends on the vagaries of gold or silver discoveries is inherently unstable.

During the 20th century most advanced economies converted to a fiat money system by taking two steps. The first step was government paper money backed by gold or silver. This gold or silver backing was necessary to get the public willing to use paper money; as they used it, the public gained confidence in it. The second step was the removal of the gold and silver backing. It turned out that despite this removal, the public continued to use paper money with confidence. These two steps remind me of the three steps used to get children to ride a two-wheel bicycle. The first step is to provide training wheels—without training wheels, many children would be afraid to try for fear of falling. The second step is to remove the training wheels but have an adult hold the seat of the bicycle to keep the child from falling. The third step is to have the adult let go of the seat.

Sachs and Larrain make a key point about the current treatment of Federal Reserve notes held by the public as a liability on the Fed’s balance sheet. They point out that the outstanding stock of Fed notes held by the public is usually the largest liability of the Fed. But they ask this question: In what sense is this really a liability—something that the Fed owes? Under the gold standard, holders of government paper money

had the legal right to convert money into gold at the Fed at a fixed price. This made the paper money a clear liability because the Fed had to supply gold in return for paper money to anybody that demanded gold. But once that government pledge was removed, there is no longer an automatic right to convert paper money into anything else. Sachs and Larrain provide an anecdote that makes the point. In 1961 Senator Paul Douglas, then chairman of the Joint Economic Committee, met with Douglas Dillon, the US secretary of the treasury. Senator Douglas gave Secretary Dillon a $20 bill, urging him to honor his liability. Dillon didn’t hesitate: he accepted Douglas’s $20 bill and gave him two $10 bills.

Similarly, Karl Whelan (2015), a professor of economics at University College Dublin, wrote that a central bank’s “liabilities” differ from the liabilities of a private bank or business. He pointed out that under the gold standard, a central bank owed gold to anyone holding paper money who wanted to exchange paper for gold, but in a modern fiat currency system, the central bank doesn’t owe anything to a holder of paper money. In a fiat money system, the conventional listing of central bank notes held by the public as a “liability” on the central bank’s balance sheet should be viewed as “notional.” Later in his article Whelan stated that there is no good basis for the view that central banks assets need to be greater than their “notional” liabilities in order for the central bank to function successfully.

I wish Whelan had simply written that central bank notes held by the public should not be listed at all under central bank liabilities. Listing government paper notes held by the public in the liabilities column, even with a footnote that this entry is “notional,” would continue to mislead many who glance at or read the central bank’s balance sheet. In my view, the proper solution is to delete central bank paper money held by the public from the list of central bank liabilities, rather than list it as a “notional”

liability and then try to persuade the public not to worry about the central bank’s apparent negative capital (net worth).

In an article with the title “Accounting for Sovereign Money: Why State-Issued Money Is Not ‘Debt,’ ” Dyson and Hodgson (2016) contend that government paper money held by the public is not government debt in a fiat money system. They begin with an examination of two sources that accountants use: The International Accounting Standards (IAS) and International Financial Reporting Standards (IFRS). They report that a “financial liability” is defined as “a contractual obligation to deliver cash or another financial asset to another entity.” Debt obliges the debtor to deliver something of value to the creditor. Usually the debt contract specifies when it must be settled and what must be delivered. When the government is the supposed debtor and the holder of government paper money is the supposed creditor, the government has no obligation to settle or deliver anything to the holder of paper money. Thus, government paper money is not government debt. By contrast, a government bond is government debt because the government is obliged to pay specific amounts of money—principal plus interest—to the holders of government bonds. Dyson and Hodgson then observe that paper money held by the public is still listed as a central bank liability even though the central bank has no obligation to pay anything to the holders of paper money.

The Fed Can Create Assets

The Fed can order new Fed notes and store them in its vault. These vault notes are Fed assets. The volume of notes the Fed can order and store can be very large if necessary. Of course, the Fed’s goal should be to inject the right amount of money into the economy—enough to avoid recession, but not enough to generate inflation. If paying off Fed liabilities would inject too

much money into the economy and generate inflation, the Fed can and should sell Treasury bonds and other assets to withdraw the excess money from the economy. Thus, the Fed can make its total assets as large as necessary by ordering and storing new Fed notes in its vault without generating inflation. As long as the Fed exercises its power to order and store notes, it can always make its total assets exceed its total liabilities.

Virtually all experts concede that the Fed can do this. One prominent expert is former Fed chairman Alan Greenspan. In a speech when he was chairman of the Fed, Greenspan (1997) stated clearly that under the current fiat money system the Fed could create assets by ordering new Federal Reserve notes. Greenspan said that a nation’s credit rating depends on the soundness of its fiscal, monetary, and regulatory policies. If there is “confidence in the integrity” of the government, in a fiat money system the central bank can issue a large amount of paper money that will be accepted by the public. The government “cannot become insolvent.” He warned, however, that issuing too much money would be inflationary and harmful. By contrast, when the Fed pledged to pay gold to holders of Fed notes, the Fed could not issue a large amount of paper money without risking becoming insolvent— unable to meet its gold pledge to holders of paper money.

Comments by Specialists in Central Bank Accounting

Several specialists on central bank accounting have recognized that current accounting is misleading. Unfortunately, they do not advocate the accounting reform I propose, but instead accept current central-bank accounting and simply point out where it is misleading. The problem with that approach is that the public and financial market participants will continue to be influenced by the current official balance sheet of a central bank. Nevertheless, here I document their concerns.

In a foreword to a paper entitled “Central Bank Finances,” Caruana (2013) wrote that, in contrast to commercial banks, central banks do not seek profits; nor do they face the same financial constraints. In fact, most central banks could keep losing money until their equity turned negative, yet still function completely successfully. The problem is that many people don’t realize this and become alarmed when they learn that a central bank’s accounting equity has gone negative. Markets may well respond poorly due to the mistaken belief of financial investors that balance-sheet losses imply an inability to conduct effective policy. Moreover, many politicians may jump to the conclusion that negative equity means that poor decisions have been made and that the central bank now needs a government bailout with taxpayer money. If politicians and financial investors knew what central bank specialists know, they would relax on learning a central bank has negative equity, and this relaxation would enable central banks to function effectively despite their negative equity. But they may not relax, and this may cause serious problems. Losses or negative capital may raise “erroneous” doubts about the central bank’s ability to deliver on policy targets, and generate political pressure on the central bank to take actions to turn its equity positive.

In the paper itself, “Central Bank Finances,” Archer and Moser-Boehm wrote that for more than a century the mission of central banks has been public policy, not private profit. Governments are the effective owners of central banks. Shares in most central banks are not for sale, so financial investors don’t need to compare central bank assets and liabilities in order to decide whether to buy shares. Central banks are protected from insolvency proceedings and can legally to operate with negative equity. Although central banks are really monetary authorities, not banks, they have retained the language and balance sheets of banks. This has misled many into thinking that a central bank,

like a commercial bank, cannot operate effectively for very long if its conventional balance sheet shows assets that are less than liabilities.

Balance-Sheet Reform and Stimulus without Debt

Recall my recommendation at the beginning of this chapter for how stimulus without debt should be handled on the Fed’s balance-sheet. Just before the Fed writes its transfer check to the Treasury, the Fed should order an amount of new Federal Reserve notes (from the usual place, the Treasury’s Bureau of Engraving and Printing) equal to its transfer to the Treasury and then store these notes in the Fed’s vault. Cash in the Fed’s vault is an asset on the Fed’s balance sheet, so the Fed’s total assets would increase by an amount equal to the Fed’s transfer to the Treasury—the same increase in total assets that would have occurred if the Fed had instead spent the same amount of money buying Treasury bonds. Moreover, just as Treasury bonds held by the Fed are not used to meet requests by banks or the public for Fed notes, neither should these new notes in the Fed’s vault; these requests for Fed notes should be met as usual by ordering additional new Fed notes, just as if the vault contained Treasury bonds instead of Fed notes. With this ordering and storing of Fed notes in the Fed’s vault, stimulus without debt would not reduce the Fed’s capital, just as the Fed’s purchase of Treasury bonds does not reduce the Fed’s capital.

But if Fed notes held by the public are deleted, as they should be, from the Fed’s list of liabilities on its balance sheet, then my recommendation in the previous paragraph would require one change: the Fed should still order and store in its vault Fed notes equal to the Fed’s transfer to the Treasury, but now the Fed’s vault cash should be used to meet requests from the public

(including banks) for Fed notes. Here is a numerical example that shows that, with this treatment, stimulus without debt would not change the Fed’s capital (net worth) on a reformed balanced sheet that correctly does not list Fed notes held by the public as a Fed liability.

Suppose in a recession Congress enacts a $450 billion fiscal stimulus package. In anticipation of writing a check for $450 billion to the Treasury, the Fed orders $450 billion of new Federal Reserve notes that the Fed stores in its vault. The Fed’s increase in vault cash of $450 billion is recorded as an increase of $450 billion in its assets on its balance sheet. So far, prior to the writing of its check to the Treasury and the implementation of the fiscal stimulus, the Fed’s capital has increased by $450 billion due to the $450 billion increase in Fed notes in its vault. After the Fed writes a $450 billion check to the Treasury, and the $450 billion of fiscal stimulus is implemented, recipients of the stimulus deposit $450 billion into their banks. Now consider three scenarios:

1. Suppose the banks keep $450 billion as deposits at the Fed.

These bank deposits at the Fed really are a Fed liability because the Fed must be ready to provide Federal Reserve notes to the banks holding these deposits at the Fed. Thus, this is recorded on the Fed’s balance sheet as an increase of $450 billion in liabilities, matching the increase of $450 billion in Fed assets due to the increase in $450 billion of

Fed notes in the Fed’s vault. Thus, from beginning to end, there has been no change in the Fed’s capital because Fed assets have increased $450 billion and Fed liabilities have increased $450 billion. 2. Suppose the banks keep no deposits at the Fed, but instead ask for $450 billion of Federal Reserve notes. The

Fed provides them with $450 billion of Fed notes from its vault, so the Fed records a reduction in its assets of $450 billion, and Fed assets are the same as before the fiscal stimulus. But the $450 billion of Fed notes held by banks are not listed as a liability on the Fed’s balance sheet. Thus, from beginning to end, there has been no change in the

Fed’s net worth (capital) because Fed assets are unchanged and Fed liabilities are unchanged. 3. Suppose the banks keep $400 billion as deposits at the Fed, and ask the Fed to provide them with $50 billion in Fed notes. The Fed provides them with $50 billion of Fed notes from its vault, so $400 billion is left in the Fed’s vault and the Fed records a reduction in its assets of $50 billion. The $400 billion of deposits at the Fed is recorded as an increase of $400 billion in liabilities on the Fed’s balance sheet. Thus, from beginning to end, there has been no change in the

Fed’s net worth (capital) because Fed assets have increased $400 billion and Fed liabilities have increased $400 billion.

Thus, if the Fed balance sheet is reformed so that Fed notes held by the public (including banks) are no longer listed as Fed liabilities on its balance sheet, and if the Fed’s new vault cash is used to meet requests from the public (including banks) for Fed notes, then stimulus without debt would not change the Fed’s capital on its reformed balance sheet.

Summary

The stimulus-without-debt policy would not weaken the Fed’s balance sheet. The policy would not reduce the capital (net worth) of the Federal Reserve on its balance sheet as long as the Fed

orders and stores in its vault new Federal Reserve notes equal to the Fed’s transfer to the Treasury under the policy. The chapter also considers a reform of the Fed’s balance-sheet accounting and shows how stimulus without debt would not reduce the Fed’s capital on the Fed’s reformed balance sheet.