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Does the Federal Reserve Need to Be Audited?

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We are writing today in response to email exchanges with notable friends and fishing colleagues who are engaged in a discussion of legislation that calls for an audit of the Federal Reserve (Fed). That is now a serious conversation taking place in Washington DC.

We have a view regarding this call to “audit the Fed.” Some of my fishing buddies will not like it and do not agree.

First, what does this term audit mean? In finance, it means that skilled professionals observe and test an institution’s or an individual’s data to verify its accuracy. Wikipedia finance defines it as “a systematic examination of books, accounts, documents and vouchers of a business to ascertain how far the financial statements present a true and fair view of the concern. It also ensures that the books of accounts are properly maintained by the concern as required by law.”

The financial community is very familiar with audits. We have them regularly. We receive and rely on certifications of accuracy from auditors. So an audit of the Fed would be a verification of its holdings.

The Fed comprises 12 regional banks. It is the regional banks that hold the assets of the Fed. They deploy them and implement policy actions. It is the regional Fed banks that are involved with other commercial banks in their regions. It is the regional banks that engage in the process of clearing payments. Each of those regional banks reports its financial condition weekly. Those reports are released on Thursday afternoons after 4:00 PM. They are publicly available and are articulated in sufficient detail as to allow any inquiry that is reasonable to be fulfilled with information readily obtainable in those reports.

The call to “audit the Fed” would suggest that there is misinformation in those reports. “Audit the Fed” would imply that when the Fed says it holds Treasury notes, bills, or bonds, federally backed mortgage securities, deposit reserves of the banking system, or excess reserves of the banking system, and engages in repurchase operations or reverse repurchase operations, that in fact those holdings and transactions are somehow incomplete or fraudulent.

“Audit the Fed” would also say that the representations of the Fed concerning its balance sheet are not accurate. That notion is absurd. When it comes to accounting issues, the Fed is already “audited,” just like any arm of the federal government. In fact, the Fed is an arm of the government with 100 years of history and is a creature created by act of Congress.

Now, there is another issue being used to conjure hyperbole and deception. The Fed is being attacked with regard to its capital structure. The antagonists say that the Fed is nearly broke, that it is leveraged 80 times its equity capital, and that if it were a private institution it would be insolvent. The fact is that the Fed is not a private banking institution; it is backed by the United States. My colleague Bob Eisenbeis had a long career within the Fed. He notes that, “As the central bank, the Fed has implicit capital representing the backing of the US government and the US Treasury. That’s the reason book capital isn’t relevant. It’s the implicit guarantee (actually, explicit guarantee) since US currency carries the logo “United States of America” and is legal tender.”

The wouldbe auditors of the Fed keep alleging that the central bank’s leverage constitutes a risk. They are guilty of purveying misinformation.

The Fed operates with no capital or only an insignificant amount. It is a central bank that does not need capital. It could operate with zero or negative capital. It could operate with a leverage ratio of 100:1, 200:1, or even 1,000:1. The Fed has an unlimited capacity to make payments. There is no issue of solvency with the central bank of the United States.

Cumberland Advisors calculates the Federal Reserve’s equity capital ratio and regularly posts the data on its website. A link to the “CUMBE Index” data can be found in the lower-right section of our home page (www.cumber.com). The direct link is http://cumber.com/content/index/duration.pdf. We use this to help us determine market sensitivities as the Fed makes policy changes. We do not use it to determine risk of the Fed failing to make a payment. We view the Fed as riskless in the same way we view the US Treasury obligation as riskless.

The CUMBE calculation includes an evaluation of the gold certificates held by the Fed at $42 per ounce. Many people ignore the gold certificates. A few people actually mark the certificates to the market and recalculate their value, on the assumption that the Treasury could revalue the market at any time. Were that to happen today, the equity ratio of the Fed would immediately change from the very low fraction of 1% to approximately 4%. So the detractors of the Fed who claim that the Fed is functioning without capital ignore the possibility of that revaluation happening at any time. The $42 dollar price could be changed by an act of the very Congress that is debating an audit of the Fed and criticizing its capital. The $42 figure came into existence when President Nixon closed the gold window at the demise of the Bretton Woods currency regime and changed the official conversion of the US dollar from $35 to $42. Nixon then stopped exchanging America’s gold for dollars. The $42 has been the legal valuation ever since.

That was in the 1970s. It was the time when Sen. William Lloyd Scott, R-VA, topped Nina Totenburg’s list of the 10 dumbest members of Congress, whereupon Scott held a press conference to refute the charge that he was the dumbest.

Let me repeat this single point, since some of the Senators who want to audit the Fed and who criticize its “leverage” choose to ignore it. They could, if they were so inclined, immediately change the price of the gold held by the Treasury and thereby change the value of the gold certificates at the Fed. By an act of Congress they could make the Fed’s capital 30 times larger if they marked the gold to its present market value.

An audit of the Fed would reveal only financial data. That data is already transparent and is already available to the general public. So if the US Congress wants to verify that the Fed is accurate in its statements, it can have an audit of the Fed -- and learn nothing new.

Who would the auditor be? It could be an outside institution engaged for a taxpayer cost. Or it could be the US General Accounting Office (GAO), which already supervises and audits the US government’s financial system. The GAO is the likely auditor.

I asked Bob Parker, former chief statistician of the GAO and a man with great experience in federal statistics, how he would audit the Fed. Bob is now retired from a distinguished career in public service. He was completely candid with me and gave me permission to quote him. He said, “Well, since there wouldn’t really be anything to do, I guess we’d just have to make something up.”

Let’s back off from the financial accounting issue of “audit the Fed” and look at Fed policy. Now we are in the realm that does not deal with audits. It deals with monetary economics.

Fed policy decides what interest rates are set, how they are set, and how they are changed. It also sets the size of bank reserves, including how much is mandatory and how much is excess and voluntary.

Those actions of the Fed are legitimate subjects for debate. They are matters for which Congress has an oversight responsibility and about which articulate financial professionals disagree. Some think Fed monetary policy is too easy; others think it’s too tight. Still others do not know. A number of us, including me, participate in surveys on a regular basis in which we offer opinions about Fed policy. We do not all agree. We have debates amongst ourselves. We even debate these issues on our annual Maine fishing trip. But the one thing that is very clear among all professionals, regardless of their views, is that the data from the Fed is accurate.

To the senator and his friends who want to “audit the Fed,” we say this: We respectfully disagree. If you want to do a service to the nation, debate Fed policy. Have thoughtful discussions about the outcomes that derive from that policy. Do not audit policy, debate it.

To act like Senator Jack S. Phogbound, banging on the table, launching into a political diatribe, and crying out to “audit the Fed” makes you look foolish. The professional community knows that you are trying to deceive the American public with your table-banging.

A separate question is, can the US can have a thoughtful discussion on Fed policy and not confuse the discussion by engaging in political distortion? We are not sure. We think that this whole notion of auditing something that is already audited and counting financial instruments that are already counted amounts to a specious distraction from the policy debate.

Those who chant “audit the Fed” represent the extremes of poor governance in Washington. They are fearful about debating policy because they are not sure of themselves. They would rather attack the central bank with political rhetoric because it is an easy target for them.

It is a sad day for the US. The US Federal Reserve is the preeminent central bank in the world, and the US dollar is the world’s reserve currency -- a currency that is strengthening. The reasons for its strength have been articulated in these commentaries. And yet here we are, engaged in this political nonsense.

It’s interesting to watch senators claim that they must “audit the Fed.” These are senators, both Democrat and Republican, who are guilty of not confirming Fed governors who were appointed by presidents, both Democrat and Republican. Thus before, during, and after the financial crisis, there were years in which the Fed’s Board of Governors had to operate with only five governors. Therefore the Fed had to make decisions on emergency powers based on the unanimity rule instead of a supermajority rule. As a result, the only recorded decisions are those for which there was a 5-0 vote. If only four of five governors were favorable and one opposed, then nothing was recorded, and it’s as if no vote was held.

It’s a counterfactual, but had the Senate confirmed the appointees sent to it, there would have been seven on the board, not five; and when issues were debated, there might have been one or more dissenters. And there would have been a record of their dissent and a record of a discussion. With a unanimity rule imposed by the Senate’s inaction, there is no record.

Why did this happen? Because the US Senate sat on their collective rear ends and would not confirm governors that presidents had appointed. They confirmed a new governor only after one of the remaining five left and there was no choice but to fill the seat. Both political parties are guilty of using Fed appointments as a political football trading apparatus. And in the case of Fed governors, culpability lies exclusively with the US Senate. The House does not confirm appointments.

The clamor to “audit the Fed” is an example of senators talking out of both sides of their mouths. They want to audit the Fed? Perhaps they should start by auditing the United States Senate, where the ratio of misleading political blustering to rational and constructive action confirms that we are suffering a national political intelligence deficit of alarming proportions.

“Audit the Fed” is a farce. Its proponents know it.

Kotok is chairman and chief investment officer of Cumberland Advisors.

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