The Fed can't go bankrupt, but it can bring the country to its knees

A recent essay on the Mises Wire triggered quite a bit of discussion among a group of Austrian school economists. Paul H. Kupiec and Alex J. Pollock's "Who Owns Federal Reserve Losses and How Will They Impact Monetary Policy?" became the focal point for a wide-ranging discussion of monetary issues that got to the heart of our monetary and overall economic future.

The Fed Cannot Go Bankrupt

The article itself gives a pretty clear explanation of how the Fed works and gives a few options for what the Fed could do if interest rates were to go up. The authors say that the Fed has put itself in a situation where it will probably lose more money as it raises rates. David Howden said that this might not happen because the Fed will roll over its mostly short-term, low-yield investments into higher-earning assets, which will protect its net interest income and give it an operating profit. Also, the Fed does not have to bring its low-yield investments up to market value. If the Fed had to do this, it would show how weak its finances really are.

The Fed Ignores the Rule of Law

But what will be done or can be done? In the beginning of their essay, Kupiec and Pollock say that nothing will be done, even though the law that created the Fed more than a hundred years ago says that it should. The losses will not go away; instead, they will be passed on to the public without their knowledge because they will have less money to buy things. Per Kupiec and Pollock:

"Innovations" in accounting policies adopted by the Federal Reserve Board in 2011 suggest that the Board intends to ignore the law and monetize Federal Reserve losses, thereby transferring them indirectly through inflation to anyone holding Federal Reserve notes, dollar denominated cash balances and fixed-rate assets.

The "innovation" in accounting policies centers around the Fed's newly minted "deferred asset" account, to which underwater assets will be transferred. Per Kupiec and Pollock:

Today, the Federal Reserve Board's official position is that, should it face operating losses, it would not reduce its book capital surplus, but instead would just create the money needed to meet operating expenses and offset the newly printed money by creating an imaginary "deferred asset" (Section 11.96) on its balance sheet.

If the Fed had to follow the law, it would have stopped printing money years ago or been forced to shut down by its creditors. But the rule of law is not followed at all. Per Kupiec and Pollock:

The Federal Reserve Board's proposed treatment of system operating losses is wildly inconsistent with the treatment prescribed by the Federal Reserve Act.

Technically, the Fed can't fail, but that shouldn't comfort the Keynesians who run our economy. Instead, the public should be shocked. If the federal budget keeps being paid for with money, the dollar could lose all of its value, which would be a disaster like what happened in the Weimar Republic.

Unlawful Monetary Debasement Causes Capital Destruction

The people in charge of money today don't understand how money really works, so they can't imagine that their outrageous irresponsibility in monetizing government debt and openly ignoring the rule of law has real consequences. The Fed helps destroy societal capital by making it easier for money to lose value, which most people have to pay for.

The government doesn't have to answer to the law or to the public for spending money in a way that hurts people. The point of going bankrupt is to force a business or government organization to stop wasting money. Economists from the Austrian school know that capital can only be made through hard work, innovation, thrift, and, most of all, savings. The market gives scarce capital to businesses that make things that are worth more than the capital they use.

The Solution Is a "Return to Sound Money"

In 1953 Ludwig von Mises added a relatively short final chapter to his 1913 masterpiece The Theory of Money and Credit. Chapter 3 of part 4 is titled "The Return to Sound Money." It is as relevant today as it was almost seventy years ago. Mises explains how the US in particular could anchor the dollar to its gold reserves. The Fed would be eliminated and replaced by little more than a board that would monitor all dollars to make sure they are backed 100 percent by gold.

Mises was a master in presenting what self-serving Keynesian scholars try to hide in a fog of deception; i.e., that money can and should be subject to the rule of law, as are all other economic goods in society. I daresay that there is no single reform that comes closer to fostering peace, freedom, and prosperity than a "return to sound money."

=========