Audit the Fed

Congressman Ron Paul has been trying to have Congress audit the Federal Reserve for years. In the past, few other Congressmen were interested. However, during the current session, he found 282 co-sponsors for HR 1207. While I have never been opposed to having Congress audit the Fed, I shared the past apathy of most members of Congress. The Fed is regularly audited by leading accounting firms. For example, Deloitte did the 2008 audit. What is the point of having an additional audit by Congress?

Worse, I worried that Congressman Paul was pandering to some of his more conspiracy-minded supporters. If you search the web for “Fed ownership,” more than nine million hits return. Most claim that the Fed is a privately-owned corporation. They further claim that the Fed pays a few cents for printing a dollar bill. Then, according to this tale, the Fed lends out the newly-created money at interest, recovering the printing cost. The secret cabal of international bankers rakes in one dollar of profit on each dollar bill. How can they get away with it? Supposedly, the Fed has never been audited. Once the Fed is audited, the “banksters’” will no longer be able to siphon off these supposedly vast profits.

This conspiracy theory is a confused mess. The Federal Reserve system is made up of twelve Federal Reserve banks. For example, Charleston is located in the district of the Federal Reserve bank of Richmond. Each Federal Reserve bank is organized as a corporation. The member banks, ordinary commercial banks located in the district, are the stockholders. For example, BB&T is part owner of the Federal Reserve bank of Richmond. Each member bank must buy stock equal to three percent of its capital, or net worth. The stock always has a price of $100, and the Federal Reserve banks issue or retire stock according to the amount each member bank is required to own. The Fed pays the banks an 8 percent dividend on that stock-- $8 per $100 share of stock.

The Federal Reserve banks pay the Treasury to have currency printed. The average cost this year is expected to be nearly nine cents per note, but that includes fives, tens, twenties, and hundreds as well as ones. While the Fed has always made loans to banks, until recently, the total amount of these loans were insignificant compared to Fed’s portfolio of government bonds. In June 2007, the Fed had $187 million lent out to banks while it had purchased $790 billion in government bonds.

The Fed makes loans to banks and purchases government bonds by adding funds to the reserve balances of banks—simply making entries in its computer. So, the immediate cost of creating money is effectively zero. The Fed then has currency printed as needed to meet withdrawals by banks from their reserve accounts. While the total amount of currency outstanding generally increases, most newly-printed currency replaces worn currency. Of the 9 billion notes printed in 2007, nearly 8 billion replaced worn currency.

Banks traditionally kept some funds in their reserve balances at the Fed, but the bulk of the money created by the Fed has been withdrawn and held in the form of currency. For example, in June of 2007, banks held approximately $9 billion in their reserve balances, while currency, both held by the public and vault cash in banks, was $811 billion.

The cost of printing currency and replacing it as it wears out is one of the Fed’s expenses. The Fed spent $576 million in 2007 to have currency printed. Other expenses include operating check clearing facilities and paying the nearly 20,000 Fed employees. Total expenses of the Federal Reserve system in 2007 were about $3.9 billion.

Up until a year ago, the primary source of revenue for the Fed was interest on the government bonds it held. It has always earned interest on the loans it makes to banks, as well as check processing fees. In 2007, the Fed earned $71 million in interest from loans to banks, $878 million in services fees, and $40 billion in interest on government bonds.

The difference between the Fed’s revenue and costs are its profits, which have been quite large. In 2007, the Fed made nearly $39 billion. What happens to those profits? A small fraction is paid in dividends to the member banks who “own” the Fed. Almost all is returned to the U.S. Treasury. In 2007, the Fed paid dividends of $992 million to its “owners” and turned over $35 billion to the U.S. Treasury.

So why have Congress audit the Fed? My view has changed because the Fed has changed. The Fed still issues currency, more than $900 billion in September, but banks now hold $884 billion in reserve accounts in the Fed, perhaps because the Fed now pays .2 percent interest on those balances. The Fed has nearly $1.8 trillion to “invest.”

More importantly, the Fed has greatly reduced its holdings of government bonds. In December 2008, Fed holdings of government bonds had fallen to $475 billion, though they increased back to $656 billion as of June. Rather than making a small amount of short term loans to depository institutions secured by government bonds, the Fed has vastly increased its lending to a variety of financial institutions. The Fed was lending $650 billion to depository institutions in December 2008 and the September figure is still $300 billion. They have accepted various sorts of collateral, including mortgage backed securities—so called toxic assets. The Fed current holds $766 billion in mortgage-backed securities.

Which financial institutions borrowed exactly how much from the Fed? The Fed refuses to say. No longer is the Fed just issuing currency and buying government bonds. It is instead directing credit to favored sectors of the economy. Is it directing credit to favored financial institutions as well? Yes Dr. Paul, is past time for an audit of the Federal Reserve.