The Federal Reserve, which has the power to print money, also sets its own operating budget. That’s the wrong kind of independence. Unfortunately, recent proposals to audit the Fed do not address this issue.
Putting the Federal Reserve on a Congressional budget would bring much-needed accountability and fairness, instill a culture of efficiency, and increase effectiveness. An annual Congressional appropriation process would do more to bring long-term accountability to the Fed than the popular audit proposal.
The Fed’s mid-1980s bailout of Continental Illinois Bank and Trust Company, then the nation’s seventh largest bank, illustrates the need for such a process. An accounting shell game hid the Fed’s loan to Continental Illinois, which was “not recorded in the FDIC’s budget because the FDIC did not provide any ‘budgetary resources,’ [and the] loan is not recorded in the budget under the Federal Reserve’s account because the discount operations of the Federal Reserve are excluded from the budget,” according to a 1985 Congressional Budget Office report (“The Budgetary Status of the Federal Reserve System”). The FDIC later assumed the $3.5 billion Fed loans after insolvency sent the bank into receivership.
This clandestine Fed bailout of Continental Illinois helped spawn the “too-big-to-fail” problem, and led to various broad-based reform proposals over the years from Democrats Alan Cranston, Lee Hamilton and Byron Dorgan and Republicans Jack Kemp and Mack Mattingly. Had Congress put the Fed on a budget back then, we might have avoided the recent financial crisis.
For a real-world example of reform, we can look to New Zealand, which in 1989 put its central bank on a fixed annual budget for five years. Central bank chairman Don Brash pleaded for a cost-of-living adjustment. Prime Minister Ruth Richardson retorted, “You believe in price stability, prove it.” After five years, the New Zealand central bank was under-spending its budget by 38 percent, and after ten years it had reduced its staff from about 600 to 285.
New Zealand’s central bank aligned incentives. As Brash explained, “So the inflation rate has no direct bearing on the budget of the Bank, except that the budget of the Bank is set on the presumption that prices are stable, so that if prices are not stable, we are put under some pressure.” Meanwhile, the Federal Reserve Board’s expenses have increased significantly in recent years.
The Federal Reserve’s funding process is little understood, and therefore little scrutinized. That needs to end. Here’s how it works: The Fed buys Treasury securities with money it creates out of thin air. The major source of the Fed’s revenue is taxpayer-funded interest on those bonds. The Fed spends however much it wants and rebates the remainder to the Treasury. This end-run around the Congressional budget process violates the spirit of the Constitution, which grants all budget power to Congress.
Former Reagan Treasury official David Malpass recently explained the importance of examining the composition of the Fed’s portfolio of Treasury bonds to the Senate Budget Committee. “We have a full-blown fiscal crisis underway which requires an upheaval in our federal spending and budgeting culture,” he said. “We face the risk of a catastrophic tipping point due to our enormous federal debt and the growth in spending. Adding to the risk, the maturity of the national debt is dangerously short, made worse by the Federal Reserve’s buyback of long-maturity debt.”