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ADV PART II
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Market Commentary

Three Myths and Misunderstandings
January 14, 2013  Bob Eisenbeis, Vice Chairman & Chief Monetary Economist

 The last couple of days have emphasized how much misunderstanding exists about government policy and the Fed, even among supposedly seasoned members of the financial press.  For example, in last Friday’s Wall Street Journal it was reported that the Federal Reserve had remitted a record “$88.9 billion in profits to the Treasury Department.”  That Fed remittances are considered profits is a total misrepresentation and a fiction.  As I have written previously, the Fed is part of the government and is not a private-sector, profit-making entity.  (The Federal Reserve Banks are quasi-public, but the Board of Governors is a government agency, and the system’s debts are guaranteed by the government.)  The Fed purchases Treasury debt from the public, paying for that debt with deposits it creates by a stroke of the pen.  Looking at the Fed’s portfolio of securities from the perspective of the nation’s consolidated balance sheet, we see that one form of government debt (Treasury debt) is taken out of circulation and replaced with another form of government debt (Federal Reserve liabilities).  In effect, Treasury debt is taken out of circulation and is now owned by the government.  It just happens to be the debt is on the books of the Fed and not the Treasury, but that is simply an accounting artifact and effectively the debt has been retired.  The Treasury pays the Fed interest, which is an intra-governmental transfer of funds.  From the funds received from Treasury, the Fed extracts both its operating expenses and contributions to capital, makes the required 6% dividend payment to member banks, and remits the remainder back to the Treasury.  Put another way, one entity of the government – the US Treasury – pays interest to another entity – the Federal Reserve, which covers its costs and returns the remainder to the Treasury.  As I put it in a previous commentary, if I wrote a $100 check and gave it to my wife, who used $10 to buy groceries and gave back to me the remaining $90, no one would say that I made a profit on that transaction or would fail to understand that all we had actually done, as a family, was to spend $10 on groceries.  If the transfer of interest between the Treasury and the Fed were settled the same way as interest rate swaps are settled (wherein only the net difference between what is owed is transferred), there would always be a net transfer of funds from the Treasury (and taxpayer) to the Fed, which uses the money to buy its groceries and pay its bills without seeking congressional appropriations.

The second Fed myth surfaced again in several responses to David Kotok’s most recent commentary on the “Tax Barbell,” in which he described how the recent tax bill that supposedly avoided the so-called fiscal cliff actually punishes the poor and working segments of the population.  Respondents argued that the tax increase was necessary, especially the payroll-tax hike, to support the Social Security Trust Fund.  Here is the second myth – despite what the public believes, there is no Social Security Trust Fund. What the government calls the Social Security Trust Fund is nothing but an accounting entity whose only assets are Treasury debt.  Payroll Social Security taxes go directly into the general fund of the Treasury and are spent like other tax receipts.  Despite what the average citizen believes, employee contributions in the form of the payroll tax to Social Security are not set aside for the future, but are spent and gone.  The only assets the Trust Fund has are claims on future tax revenues or debt issuance represented by its holdings of US Treasury debt.  It happens that, right now, Social Security’s receipts exceed its payments to pensioners, but the fact is that the revenue used to pay retirees today comes from current payments from active workers, not from reserves accumulated from funds retirees paid in when they were working. Those reserves don’t exist. There is no accumulated “savings account.” As more and more baby boomers retire, Social Security disbursements will exceed receipts, and the fiction of the trust fund will be exposed.  This accounting charade needs to be fixed and Social Security funding issues addressed.  But the recent Congressional approach isn’t the answer and certainly isn’t a fix.

Finally, a tongue-in-cheek proposal that was getting traction in DC was that the Treasury (and thus the Administration) could solve its funding problems by simply exploiting a loophole in the law that would permit the Treasury to mint a trillion-dollar platinum coin, deposit it in the Treasury’s account with the Fed, and write checks on that account to cover operating costs.  Shame on us that we are even talking about the possibility, and even Paul Krugman has weighed in on the issue. To mint the coin would be to print money, and we know from history that printing money doesn’t solve a debt problem.  The Spanish found that out when they scoured the world for gold. The more of it you have in circulation, the less valuable it becomes.  The Germans found it out during the Weimar Republic, and the Argentineans found it out in the latter half of last century.  Krugman claims it isn’t printing money because the Fed would offset Treasury spending, which would put new money in the hands of the public, with asset purchases.  But he is wrong, since he is assuming behavior by another governmental entity to offset the Treasury’s spending and hasn’t apparently looked recently at the Fed’s exploded balance sheet.  As the result of its quantitative easing programs, there are no offsetting transactions and wouldn’t likely be such transactions.  Fortunately, some semblance of rationality on this issue emerged this past weekend from the Administration and the Fed.  An administration spokesman announced there would not be such a coin, nor would the Fed accept it in return for a deposit if it existed.  He went on to state that the budget and debt ceilings are Congress’ problems and up to them to fix.

Bob Eisenbeis, Vice Chairman & Chief Monetary Economist

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