A Frightening Solution to the Debt Ceiling Crunch

Published in Law & Liberty by Alex J. Pollock and Paul H. Kupiec.

Could the debt ceiling crunch be avoided by the Federal Reserve forgiving treasury debt? Let's hope not.

Much has been written about the Congressional debt-ceiling standoff. US Treasury and Federal Reserve Board officials have insisted that the only way to prevent a federal government default on its debt is for Congress to simply raise the debt ceiling without requiring any reduction in spending and deficits.

However, more imaginative measures could be taken to forestall a general federal government default without increasing the debt ceiling. For example, we have previously shown that legislation that increases the statutory price of the US Treasury’s gold holdings from its absurdly low price of $42.22 per ounce to something close to gold’s $2000 per ounce market value provides an efficient process—one historically used by the Eisenhower administration—to significantly increase the Treasury’s cash balances and avoid default while budgetary debate continues.

In this note, we explore, as a thought experiment, the possibility that the cancellation of up to $2.6 trillion of the $5.3 trillion in Treasury debt owned by the Federal Reserve System could be used to avert a federal government default without any increase in the debt ceiling. We suggest that, given the enforcement of current law, federal budget rules, and Federal Reserve practices, such an extraordinary measure not only would be permissible, but it could be used to entirely circumvent the Congressional debt ceiling.

The Federal Reserve System owns $5.3 trillion in US Treasury securities, or about 17% of the $31 trillion of Treasury debt outstanding. The Fed uses about $2.7 trillion of these securities in its reverse repurchase agreement operations, leaving the Fed with about $2.6 trillion of unencumbered US Treasury securities in its portfolio.

What would happen if the Fed “voluntarily” released the Treasury from its payment obligations on some of all of the unencumbered US Treasury securities held in the Fed’s portfolio, by forgiving the debt? We believe there is nothing in Constitution or the Federal Reserve Act that would prohibit the Fed from taking such an action. This would free up trillions in new deficit financing capacity for the US Treasury without creating any operating difficulties for the Federal Reserve.

There is a longstanding debate among legal scholars as to whether the Fourteenth Amendment to the Constitution makes it unconstitutional for the federal government to default on its debt. But voluntary debt forgiveness by the creditor on the securities owned by the Federal Reserve would not constitute a default and the arguments related to the Fourteenth Amendment would not be applicable.

The Federal Reserve System is an integral part of the federal government, which makes such debt forgiveness a transaction internal to the consolidated government. However, the stock of the twelve Federal Reserve district banks is owned by their member commercial banks. Would it create losses for the Fed’s stockholders if the Fed absolved the US Treasury of its responsibility to make all payments on the US Treasury securities held by the Fed? We don’t think so.

The Fed has already ignored explicit passages of the Federal Reserve Act that require member banks to share in the losses incurred by their district Federal Reserve banks. Under its current operating policies, the Fed would continue to pay member banks dividends and interest on member bank reserve balances even if the entire $2.6 trillion in unencumbered Treasury debt securities owned by the Federal Reserve System were written off. Such a write-off would make the true capital of the Federal Reserve System negative $2.6 trillion instead of the negative $8 billion it is as of April 20.

The Federal Reserve Act requires member banks to subscribe to shares in their Federal Reserve district bank, but member banks need only buy half the shares they have pledged to purchase. The Federal Reserve Act stipulates that the “remaining half of the subscription shall be subject to call by the Board.” At that point, the member banks would have to buy the other half. Presumably, the Fed’s founders believed that such a call would be forthcoming if a Federal Reserve Bank suffered large losses which eroded its capital.

In addition, Section 2 of the Act [12 USC 502] requires that member banks be assessed for district bank losses up to twice the par value of their Federal Reserve district bank stock subscription.

The shareholders of every Federal reserve bank shall be held individually responsible, equally and ratably, and not one for another, for all contracts, debts, and engagements of such bank to the extent of the amount subscriptions to such stock at the par value thereof in addition to the amount subscribed, whether such subscriptions have been paid up in whole or in part under the provisions of this Act. (bold italics added)

To summarize, Fed member banks are theoretically required to buy more stock in a losing Federal Reserve district bank and to be assessed to offset some of the Reserve Bank’s losses. However, these provisions of the Federal Reserve Act have never been exercised and are certainly not being exercised today, in spite of the fact that the Fed’s accumulated losses are now greater than its capital. Indeed, the Fed consistently asserts that it is no problem for it to run with negative capital however large that capital shortfall may become.

Historically, all Fed member banks were entitled to receive a 6 percent cumulative dividend on the par value of their paid-in shares. Subsequently, Congress reduced the dividend rate for large banks to the lesser of “the high yield of the 10-year Treasury note auctioned at the last auction” (currently 3.46%), but maintained the 6% for all others. The Fed is now posting large operating losses but is still paying dividends to all the member banks. We confidently predict it will continue to do so.

Unlike normal shareholders, member banks are not entitled to receive any of their Federal Reserve district bank’s profits beyond their statutory dividend payment. The legal requirements and Federal Reserve Board policies governing the distribution of any Federal Reserve System earnings in excess of its dividend and operating costs have changed many times since 1913, but today, the Fed is required by law to remit basically all positive operating earnings after dividends to the US Treasury—but now there aren’t any operating earnings to remit.

Beginning in mid-September 2022, the Federal Reserve started posting cash losses. Through April 20, 2023, the Fed has accumulated an unprecedented $50 billion in operating losses. In the first 3 months of 2023, the Fed’s monthly cash losses averaged $8.7 billion. Notwithstanding these losses, the Fed continues to operate as though it has positive operating earnings with two important differences—it borrows to cover its operating costs, and it has stopped making any remittances to the US Treasury.

The Fed funds its operating loss cash shortfall by: (1) printing paper Federal Reserve Notes; or (2) by borrowing reserves from banks and other financial institutions through its deposits and reverse repurchase program. The Fed’s ability to print paper currency to cover its losses is limited by the public’s demand for Federal Reserve Notes. The Fed borrows most of the funds it needs by paying an interest rate 4.90 percent on deposit balances and 4.80 percent on the balances borrowed using reverse repurchase agreements. These rates far exceed the yield on the Fed’s investments.

In spite of its losses, the Fed continues to pay member banks both dividends on their shares and interest on their reserve deposits. The Fed has not exercised its power to call the second half of member banks’ stock subscriptions nor has it required member banks to share in the Fed’s operating losses.

Instead of assessing its member banks to raise new capital, the Fed uses nonstandard, “creative” accounting to obscure the fact that it’s accumulating operating losses that have rendered it technically insolvent.

Under current Fed accounting policies, its operating losses accumulate in a so-called “deferred asset” account on its balance sheet, instead of being shown as what they really are: negative retained earnings that reduce dollar-for-dollar the Fed’s capital. The Fed books its losses as an intangible “asset” and continues to show it has $42 billion in capital. While this treatment of Federal Reserve System losses is clearly inconsistent with generally accepted accounting standards, and seemingly inconsistent with the Federal Reserve Act’s treatment of Federal Reserve losses, Congress has done nothing to stop the Fed from utilizing these accounting hijinks, which the Fed could also use to cancel the Treasury’s debt.

Under these Fed operating policies, if all of the unencumbered Treasury securities owned by the Fed were forgiven and written off, the Fed would immediately lose $2.6 trillion. It would add that amount to its “deferred asset” account. Because the Fed would no longer receive interest on $2.6 trillion in Treasury securities, its monthly operating losses would balloon from $8.7 billion to about $13 billion, for an annual loss of about $156 billion. Those losses would also go to the “deferred asset” account. Treasury debt forgiveness would delay by decades the date on which the Fed would resume making any remittances to the US Treasury, but by creating $2.6 trillion in de facto negative capital, the Fed would allow the Treasury to issue $2.6 trillion in new debt securities to keep on funding federal budget deficits.

Under the federal budgetary accounting rules, the Fed’s deferred asset account balances and its operating losses do not count as expenditures in federal budget deficit calculations, nor do the Fed’s borrowings to fund its operations count against the Congressionally imposed debt ceiling. So in short, the Fed offers a way to evade the debt ceiling.

In reality, of course, the debt of the consolidated government would not be reduced by the Fed’s forgiveness of Treasury debt. This is because the $2.6 trillion the Fed borrowed (in the form of bank reserves and reverse repurchase agreement loans) to buy the Treasury securities it forgives would continue to be liabilities of the Federal Reserve System it must pay. The Fed would have $2.6 trillion more liabilities than tangible assets, and these Fed liabilities are real debt of the consolidated federal government. But in accounting, the Fed’s liabilities are uncounted on the Treasury’s books. Under current rules, there appears to be no limit to the possibility of using the Fed to expand government debt past the debt ceiling.

In other words, the Fed’s write-off of Treasury securities and its ongoing losses could accumulate into a massive amount of uncounted federal government debt to finance deficit spending. A potential loophole of trillions of dollars around the Congressional debt limit is an astonishing thought, even by the standards of our current federal government. Let’s hope Congress closes this potentially massive budgetary loophole while the idea of the Fed’s forgiving Treasury debt remains just a thought experiment.

Alex J. Pollock is a Senior Fellow at the Mises Institute and was the principal deputy director of the office of financial research of the U.S. Treasury Department, 2019-21. He is author of Finance and Philosophy—Why We’re Always Surprised and co-author of Surprised Again!—The COVID Crisis and the New Market Bubble.

Paul H. Kupiec is a senior fellow at the American Enterprise Institute, where he studies systemic risk and the management and regulations of banks and financial markets. Before joining AEI, Kupiec was an associate director of the Division of Insurance and Research within the Center for Financial Research at the Federal Deposit Insurance Corporation (FDIC) and director of the Center for Financial Research at the FDIC and chairman of the Research Task Force of the Basel Committee on Banking Supervision. He has previously worked at the International Monetary Fund (IMF), Freddie Mac, J.P. Morgan, and for the Division of Research and Statistics at the Board of Governors of the Federal Reserve System.