Willem Buiter | The Fed’s capital falls into negative territory
Is it a problem?
On August 30, the US Federal Reserve System’s Consolidated Statement of Condition recorded total capital of US$42.72 billion.
This figure would have been negative but for the appearance of an US$87.15-billion negative liability, driven by minus US$95.12 billion in earnings remittances to be paid to the US Treasury.
But make no mistake: this negative liability, known as a deferred asset, is an accounting gimmick that allows the Fed to avoid having to report negative total capital – equity or net worth – on its balance sheet.
The Fed explains this deferred asset as follows:
The Federal Reserve Banks remit residual net earnings to the US Treasury after providing for the costs of operations, payment of dividends, and the amount necessary to maintain each Federal Reserve Bank’s allotted surplus cap. Positive amounts represent the estimated weekly remittances due to US Treasury. Negative amounts represent the cumulative deferred asset position, which is incurred during a period when earnings are not sufficient to provide for the cost of operations, payment of dividends, and maintaining surplus. The deferred asset is the amount of net earnings that the Federal Reserve Banks need to realise before remittances to the US Treasury resume.
Without this deferred asset, the total capital would have been minus US$52.40 billion, and the Fed would be in the same territory as the Czech National Bank, which has had negative equity for most of the past 20 years, as well as the central banks of Sweden, Chile, Israel, Mexico, and Australia – all of which reported negative equity at the end of 2022.
If central banks had to market their assets not only when they are sold, but also when listing their available-for-sale and held-to-maturity portfolios, capital losses on long-dated securities and loans driven by the post-COVID rise in interest rates would put most advanced-economy central banks in the red.
But why doesn’t the Fed just report negative capital? After all, there is no presumption that it will be equitably insolvent or unable to meet current and future contractual obligations. Negative capital, sometimes referred to as balance sheet insolvency, does not imply equitable or cash flow insolvency, where one can no longer pay obligations as they fall due.
As long as the Fed does not have material net foreign currency-denominated liabilities, it can always print its way out of insolvency troubles, because it holds a monopoly over the issuance of legal tender. The amount of monetisation required to avoid equitable insolvency may, however, be incompatible with the inflation target.
Central bank equitable (in)solvency should be considered not in terms of the conventional balance sheet – which lists only legal, contractual obligations as assets and liabilities – but of the comprehensive balance sheet or intertemporal budget constraint. The comprehensive balance sheet does not list the outstanding stock of central bank monetary debt as a liability, because it is a liability in name only.
While undoubtedly perceived as an asset by its holder, a given amount of central bank currency is merely a claim only on that amount of central bank currency. One asset and two liabilities are added. The asset is the present discounted value, or PDV, of current and future net seigniorage, meaning the issuance of central-bank money minus any interest paid on the outstanding stock of central-bank money.
The key liability is the PDV of current and future net remittances to the Treasury – the beneficial owner of the Federal Reserve System. The second liability is the PDV of the current and future costs of running the central bank. I take that as given, and I ignore the PDV of net non-interest payments to the private sector – ‘helicopter money’, if monetised.
The Fed’s “deferred asset” allows it to set some positive benchmark for conventional equity. Any income losses or capital losses that would threaten to drive actual net worth below the threshold level are neutralised by a matching reduction in the PDV of net transfer payments from the central bank to the Treasury. If the losses are large and persistent enough, this could result in a sequence of negative net transfer payments to the Treasury, or even a negative PDV of all current and future net remittances.
The alternative would be to increase current and/or future seigniorage, which would have implications for monetary policy and the Fed’s ability to pursue its dual mandate of maximum employment and price stability. But the Fed has not entertained this option.
These kinds of negative net transfer payments from the central bank to the Treasury – when central bank capital falls below some threshold level – are part of the relevant memorandum of understanding between the Bank of England and the His Majesty’s Treasury. But recapitalisation is not part of the legislative and regulatory framework that connects the Fed and the US Treasury.
The Fed’s deferred-asset construction assumes that it can set the PDV of net remittances to the Treasury at any level, negative as well as positive, even though that is clearly not the political reality in the United States.
The good news is that even without recapitalisation of the Fed by the Treasury, the losses and negative equity levels thus far have not called for additional monetary issuance of a magnitude that is inconsistent with the effective pursuit of the inflation target. The sums involved, around US$95 billion, are dwarfed by a balance sheet that still exceeds US$8 trillion.
Nonetheless, it makes sense for the United States to introduce a British-style recapitalisation agreement between the Fed and the Treasury. Doing so would ensure that, should losses continue to mount, the Fed will not have to choose between avoiding equitable insolvency and effectively abandoning its inflation target.
Willem H. Buiter, a former chief economist at Citibank and former member of the Monetary Policy Committee of the Bank of England, is an independent economic adviser. © Project Syndicate 2023 Email: www.project-syndicate.org