Like the Spaniard in The Princess Bride knew he needed the Man in Black, when I try to parse the Fed’s notorious January 6 accounting change, I know I need the economist who wrote this article (“Who Owns the Fed?”).
So here’s the Fed’s announcement, with my placeholders and bolding added:
The Board’s H.4.1 statistical release, “Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks,” has been modified to reflect an accounting policy change that will result in a more transparent presentation of each Federal Reserve Bank’s capital accounts and distribution of residual earnings to the U.S. Treasury. [#1] Although the accounting policy change does not affect the amount of residual earnings that the Federal Reserve Banks distribute to the U.S. Treasury, it may affect the timing of the distributions. Consistent with long-standing policy of the Board of Governors, the residual earnings of each Federal Reserve Bank, after providing for the costs of operations, payment of dividends, and the amount necessary to equate surplus with capital paid-in, are distributed weekly to the U.S. Treasury. The distribution of residual earnings to the U.S. Treasury is made in accordance with the [#2] Board of Governor’s authority to levy an interest charge on the Federal Reserve Banks based on the amount of each Federal Reserve Bank’s outstanding Federal Reserve notes.
Effective January 1, 2011, as a result of the accounting policy change, [#3] on a daily basis each Federal Reserve Bank will adjust the balance in its surplus account to equate surplus with capital paid-in and, in addition, will adjust its liability for the distribution of residual earnings to the U.S. Treasury. [#4] Previously these adjustments were made only at year-end. Adjusting the surplus account balance and the liability for the distribution of residual earnings to the U.S. Treasury is consistent with the existing requirement for daily accrual of many other items that appear in the Board’s H.4.1 statistical release. The liability for the distribution of residual earnings to the U.S. Treasury will be reported as “Interest on Federal Reserve notes due to U.S. Treasury” on table 10. [#5] Previously, the amount necessary to equate surplus with capital paid-in and the amount of the liability for the distribution of residual earnings to the U.S. Treasury were included in “Other capital accounts” in table 9 and in “Other capital” in table 10.
For those who don’t see what the big deal is in the above–and you’re not alone, it took the financial sector a good two weeks to realize it–see Robert Wenzel’s analysis.
So my questions for Woolsey, who (by my back-of-the-envelope calculations) has written a novella in his arguments with Captain Freedom on this blog, and so should jump at the chance to share his wisdom with a wider audience:
#1: Here, are they referring to the fact that if the Fed suffers a capital loss, it will halt the flow of remitted earnings to the Treasury, until that loss is whittled away? If so, are they being honest when they say it won’t affect the total flow of earnings, but rather just the timing? Before this rule change, how would the Fed ever have recapitalized itself after taking a hit? Would it have happened more gradually, so that the flow of remitted earnings to the Treasury would have been reduced more modestly, but for a longer period, than will be the case now?
#2: What the heck are they talking about? I don’t think I ever knew that the Fed had to pay interest on Federal Reserve Notes. Is that just some internal costing mechanism to allocate the burden of remitted earnings among the various Fed banks? And what is the interest rate?
#3: Can you say this in English?
#4: They are making it sound as if they are simply doing something daily, which previously would have been done yearly. Is that correct? And if so, then why is everybody acting as if the Fed is doing something crooked? Was it standard practice to skirt insolvency on an annual basis before, and now it’s done weekly?
#5: This is the money line, right? The Fed is making it sound like it’s just putting its “surplus” somewhere besides its “capital account,” when this also opens the door to them putting a negative surplus–aka a loss–somewhere besides its capital account. If I’ve read that correctly, then can you relate it to a standard balance sheet? A lot of people are saying stuff like, “The Fed is moving its losses off the left-hand side of its balance sheet.” But that’s not how I’m reading that. I think they will still reduce the value of their assets, but then on the Liabilities and Capital side, they won’t reduce Capital correspondingly. In order to make the right hand side fall as much as the Assets fell, they will instead put in a negative number in the Liabilities. This pulls down the right hand side of the balance sheet, while still maintaining Assets > Liabilities.
Is this about right? And of course people other than Bill Woolsey can chime in.