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Episode 13 - The Accounts

Does the Fed pay taxes? Does it make a profit? Today’s episode covers one of the most important distinguishing characteristics of the central bank. We answer these and a few other interesting questions about accounting in the Centralverse.

Intro

This is The Bankster Podcast, and I’m your host, Alexander Bagehot. Today is Episode 13 - The Accounts. Every episode we dive into the intricate world of central banking! I use one or two pieces of news from the Federal Reserve or monetary policy from around the world to summarize, translate, and explain a few points from the Centralverse. Now the Centralverse is the deep, the fascinating, the ever changing, and the incredibly consequential world of central bankers and the economies they attempt to support.

Early last week I was speaking to a group of Chinese businessmen and women about the Federal Reserve. They were an especially attentive group and had a wonderful supply of questions about how the Central Bank here in the United States works. One of the first questions they asked me was something I get all the time, “We’ve heard that the Federal Reserve is part government and part private. How does this work?” Hopefully if you’ve been a listener from the beginning of the podcast you could now answer that question with at least a small measure of confidence.

I’ve found that the best way to describe the “quasi-governmental” role of the Federal Reserve is to talk about the FOMC. I told them about the representation from Washington and the representation from all of the Reserve Banks from around the country. And finally, I described the voting structure of the committee - how seven votes come from the centralized office in Washington DC and five votes come from the Reserve Banks. This answer has always satisfied groups I’ve spoken to in the past, but this time the Chinese group wanted to drill deeper and deeper. They began to ask about the accounting practices of the Federal Reserve. They asked a series of excellent financial questions and I’ve decided for this episode to review a few of those accounting questions.

By the end of this Q&A with the Chinese group I couldn’t help but feel like they now understood the Federal Reserve on a level that very very few do. I hadn’t given it much specific thought before but learning about the accounting practices of the Fed is a really good way to learn about a central bank’s unique role in the economy. So that’s what we’ll do today. But first, let’s take a moment to define a common Centralverse word that was used in the news this week.

 

News

The word is actually a color, and not a specially exciting one either - beige. In normal conversation the color beige may come up when describing the paint of a living room wall or the fabric of a summer dress. However, in the Centralverse the color beige has a much more important status. If you had your ear on the financial news of the week you most likely heard about the release of the Federal Reserve’s Beige Book. On a future episode I will go into more detail about the fascinating history of the beige book, but for now I wanted to at least describe what it is and how it is used.

I really liked the title of an article in the Wall Street Journal this week, “Fed’s Beige Book Shows Rising Wages, but Muted Inflation Pressure”. Adjectives like rising and muted are surprisingly vague for a financial analysis article. Economists normally like numbers and most of the information that they use come in the form of solid numbers like “wages rose by 2.4%”, or “150,000 more houses were started this year than last year.” or “equilibrium price is $113”. So hearing soft and vague adjectives by the Federal Reserve is strange - unless you know what to look for.

See, the Beige Book is an economic document compiled and published by the Federal Reserve two weeks before each scheduled meeting of the FOMC. So there are eight published Beige Books a year. The document is full of adjectives and phrases like: moderate, gained momentum, constrained pace, remained tight, pressures increased, and sales softened. And these are just a few that I picked out of the first paragraphs of last week’s report.

The Beige Book is a collection of anecdotes or experiences collected by surveys done by each of the twelve Federal Reserve Banks. Some of the surveys are more informal conversations between Fed economists and business owners in each district. Other times the information is collected in a more formal written survey.

The use of softer adjectives and the lack of numbers is actually on purpose. It’s based on the idea that we have so many numbers and measures for the economy, but sometimes in order to understand what is actually going on, you need to be in touch with the people that are making big decisions about the economy - with business owners. Their stories and experiences about recent decisions are collected every 6 weeks or so by each of the twelve Federal Reserve Banks. Then all of the districts combine these stories and overviews of the economic activity into one report. Back in the day this was one of three reports that was printed hard copy and delivered to each of the FOMC committee members. Each of these reports had a different colored cover. And one of them was - you guessed it - beige.  

So now when you hear economists or journalists awkwardly avoiding specific numbers you can likely assume that they are discussing the most recently released Beige book. This is a fun topic, and the “coloring books” (as I like to call them) of the Federal Reserve each has an interesting history and purpose. But those are stories for another episode.

It’s now time to return our attention to a few of those excellent questions about Fed accounting.

Accounting Questions

I actually don’t mind accounting. I love managing my budget at home, and during my undergrad I learned a lot in my Financial and Managerial Accounting courses. And it really is the language of the financial world. But setting all of that aside, even if you have no background in accounting or took it in school and have done your best to erase the experience from your memory, stick with me - like everything in the business world, things get interesting when they enter the Centralverse.

For each of the questions that we’ll discuss today I’ll try and answer with a short answer, and then a deeper explanation. The questions will build on each other, so let’s start with arguably the most important, and definitely one of the foundations upon which all central banks are built. Question number one: Does the Fed create money? Short answer: Yes.

I’m not going to spend a ton of time on this question here, because I dedicated a good portion of Episode 5 to the Fed’s current and historical money making practices - go back and check out Episode 5 if you haven’t already, or if you need a quick refresher.

But basically, yes, the Federal Reserve has the authority to create money. It is through the exercise of this power that the FOMC influences interest rates. And remember that they raise or lower interest rates to achieve their goal of maximizing employment and keeping inflation at a healthy rate. This is an incredibly important tool to the central bankers.

Here are three common occasions in which central banks create money. (1) They create money to pay interest on reserves. This is kind of like you receiving interest on your savings account. The Fed pays interest to banks on their reserves. (2) They create money to buy assets like treasury securities or mortgage backed securities. And (3) Central Banks create money when they make loans at the Discount Window. Which is like a regular loan that a bank can get from the Federal Reserve. Central Banks use money that they created to pay for all of these things. And here comes another interesting point. Let’s take those last two items as an example. Treasury securities are bonds that pay a fixed interest rate to those that hold them. Loans made to banks at the Discount Window also pay interest. So the Federal Reserve buys a bond or makes a loan with newly created money and then earns interest on that money created.

This leads to question number two. Does the Fed make a profit? Short answer: Yes. In fact the Federal Reserve had a higher net income than any other company in the United States. In fact Apple had the highest net income of any public company in 2015 coming in at $53B. The Federal Reserve’s net income for the same year was $99B. Now the comparison is very rough, and in many ways it’s comparing apples to oranges (pun intended). But it underlines the amount of money that the Federal Reserve is making using the money that they created out of thin air.

One other way (much much smaller - in the hundreds of millions) that the Federal Reserve makes money is through providing services to the financial sector. For example, they run the Automated Clearing House (which is the wire system that all of your direct deposits from your employer go through), Fedwire (which is the network that processes all large value money transfers - an incomprehensible $4.5T every day), and Check Processing (which is where they play the middle man between your bank and the other bank when you write a check to someone who banks at a different bank). In all of these services the Federal Reserve is not the only player in the market. Because of this they are mandated by law to simply break even. Meaning they need to charge people for these services, but only the amount necessary to cover the costs of operating the service.

Which leads us to the next question for the day. With all of that money that the Federal Reserve is making, do they pay taxes? Short answer: Yes, but not all of them. I’ll list a few instances where they do pay taxes, and then a few cases where they don’t. However, let’s start somewhere in between. In regards to the services that the Fed sells that we just discussed, they do not pay taxes on those. But in order to make it fair to the other companies that offer that same service but do have to pay taxes - the Fed makes an adjustment to the price - and it’s actually listed on the Fed’s general ledger as an expense so that the Fed doesn’t push out the competition just because they don’t pay taxes.

The Fed does pay all of the social security and payroll taxes. In some states they have to pay property taxes for the buildings that they own and operate, but in other states they do not pay a property tax. They do not pay taxes on the interest income that they receive from the treasury securities or their other investments in the portfolio. And this is by far where most of the income comes from, so although the Federal Reserve does pay taxes on a number of different things, and they adjust prices to account for taxes for the services, you could have a good argument in answering the question, Does the Fed pay taxes? A few, but mostly not.

Which leads to our final question for the day: What happens to all of that money? Well, it is deposited right back into the United States Treasury account. Last year the Federal Reserve remitted (that’s what they call it when the Fed transfers the money to the Treasury) $117B. So ultimately, and probably more accurately, you could say that the Federal Reserve is taxed 100%. All of the extra money that the Fed makes from all of that money gets circled back to the government. It’s a very peculiar relationship because some of that money that the Fed gives back to the government is the very money that the government paid to the Fed as interest on Treasury securities.

So in summary: Does the Fed create money? Yes, in multiple ways. Does the Fed make a profit? Yes, a huge profit. Does the Fed pay taxes? Officially just a few. But what does the Fed do with the profit? They give it to the Treasury, which is basically like a tax.

Isn’t this interesting? No other organization, public or private, is in such a unique accounting position. This is what makes the study of central banks so fascinating. They are unlike anything else in the world.

Don’t worry about remembering all of the facts or numbers shared in today’s episode. The purpose was to learn a little bit more about the Federal Reserve by taking a dive into the accounts. The goal of any central bank has nothing to do with making money - the goal is to maintain a healthy economy. But in the process of achieving this goal they frequently make a lot of money. Keeping track of that money and deciding how to account for it is an interesting adventure. One worth studying.

Conclusion

In the show notes to today’s episode, which you can sign up for on my website, www.thebanksterpodcast.com, I’ll include links to the financial statements and a summary of today’s episode. As always, send in your comments and questions about the Centralverse or the Bankster Podcast in general via email (alexander@thebanksterpodcast.com) or Twitter or Facebook. Open up your phone now and leave a review of the podcast on whatever podcast app you’re using to listen!

Today’s episode was written, edited, and produced by me, Alexander Bagehot. I dedicate this episode to Russell Shaffer - who gave me my favorite books, sharpened my writing, and became a close friend. And to everybody else, thanks for listening. I’m Alexander Bagehot, and I’ll see you next time on The Bankster Podcast!

 

 

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