Thursday, December 27, 2012

The final draft on Fed-Treasury overdrafts

Marriner Eccles

There is an idea floating around on the internet that the US Treasury can finance itself indefinitely by borrowing directly from the Federal Reserve. All the President need do, goes the story, is order the Fed to credit the Treasury's account with fresh money, and voilĂ  – the Treasury can spend willy-nilly. This is called the Treasury's overdraft facility.

In actuality, the above operations are impossible since the Treasury is legally prevented from borrowing directly from the Fed. The result is that the Treasury can only spend by ensuring that it has already obtained funding through the collection of taxes or the issuance of securities in the open market. The overdraft facility is a myth.

But this wasn't always the case. Marriner Eccles's March 1947 hearing before the House of Representative's Committee on Banking and Currency is a great source of US monetary history. In it we learn that from 1914 to 1935, the Federal Reserve had the power to lend directly to the Treasury by purchasing newly created government debt. This was called direct-purchase authority, and it amounted to a Treasury overdraft privilege with the Federal Reserve. This overdraft facility found legal expression in section 14(b) of the act, which permitted the Fed to "buy and sell, at home or abroad, bonds and notes of the United States, and bills, notes, revenue bonds, and warrants with a maturity from date of purchase of not exceeding six months." The interpretation of this bit of legalese was that the Fed needn't limit purchases of government debt to the open market, it could buy directly from the government.

As I pointed out in an earlier post, section 16 of the Federal Reserve Act prohibited the Fed from using government securities as collateral for note backing until the passage of the first Glass Steagall Act in 1932. So even though the Fed could lend directly to the Treasury during this early period, its ability to do so was significantly crimped by the ineligibility of government bonds as backing.

We learn from the Eccles document that in 1935, the Federal Reserve Act was modified to prevent the Fed from making direct purchases of Treasury-issued securities. This was done by inserting a provision into section 14(b) of the Act requiring all purchases of government debt to be carried out in the open market. As a result, the overdraft privilege ceased to exist.

The overdraft facility was re-instituted in March 27, 1942, only a few months after the US entered World War II. The War Powers Act provided the Fed with the temporary authority to directly buy up to $5 billion of government securities from the Treasury. Specifically, the new wording of section 14(b) allowed the Fed to purchase
any bond, note, or other obligation which are obligations of the United States, or which are fully guaranteed by the United States as to principal and interest, may be bought and sold without regard to maturities either in the open market or directly from or to the United States, but all such purchases and sales shall be made in accordance with the provisions of section 12 (a) of this Act and the aggregate amount of such obligations acquired directly from the United States which is held at any one time by the 12 Reserve banks shall not exceed $5,000,000,000.
This was only a temporary power, which is why we find Fed Chairman Marriner Eccles visiting Congress in 1947. He was lobbying Washington to make the overdraft facility a permanent part of the Fed's arsenal. Eccles justified the overdraft by pointing out that it might save the taxpayer money. After all, overdrafts provided the Treasury with cheaper temporary funding than the open-market did. We know he was unsuccessful in his efforts to make the authority permanent, since this 2006 Government Accountability Office (GAO) document notes that:
Intermittently between 1942 and 1981, Treasury was able to directly sell (and purchase) certain short-term obligations to (and from) the Federal Reserve in exchange for cash. Congress first granted this cash draw authority temporarily in 1942, allowed it to lapse several times, and extended it 22 times until 1979, when it modified some of the terms and added controls.
We also learn from the GAO document that in 1981 Congress allowed the overdraft authority – referred to as "draw authority" – to permanently expire. Thus ended 39 years of Treasury overdrafts. The GAO report provides some interesting statistics on this period. Between 1942 and 1981, the Federal Reserve held Treasury certificates purchased directly from the Treasury on just 228 days, mostly during times of war. So while overdrafts were permitted, they weren't used often, and not for long periods of time. The largest amount  of certificates issued by the Treasury to the Fed on a single day was $2.6 billion in 1979. By 1979, $2.6 billion didn't amount to much, but in 1942, with the Fed's liabilities amounting to $25 billion, an extension of a $5 billion overdraft would have dramatically increased the Fed's balance sheet.

Below is a handy chart I've pinched from the GAO report which illustrates the use of the overdraft facility over time.

Note the large interwar gaps when draw authority was never used.

Section 14(b) of the modern Federal Reserve Act, amended in 1981, includes a strict "open market" provision that limits Fed purchases to "any bonds, notes, or other obligations which are direct obligations of the United States or which are fully guaranteed by the United States as to the principal and interest may be bought and sold without regard to maturities but only in the open market". This change is indicative of the broader trend to independent central banking. In a 1978 subcomittee meeting on the Fed's draw authority, Congressman George Hansen expressed this sentiment quite well:
This authority is a leftover from the days of explicit Fed support for Treasury financing, when monetary policy was clearly subordinated to the Treasury's aim of cheap deficit financing. I hope we are all agreed that monetary policy should not be thus subordinated, and that we can do without the mechanisms through which the Treasury called the shots for Federal Reserve open market operations.
And that's where we are today. The Treasury can't finance itself directly via the Fed. Yes, there may be indirect routes, but that's another post. Anyone who operates under the assumption that the direct route exists are assuming a monetary structure that became extinct in 1981.


  1. This isn't exactly on-topic, but a bigger problem with the Fed owning Treasury bonds is that those bonds are denominated in the same dollars that the Fed itself issues. So if the dollar loses value, then so do the Fed's bonds. This loss of bond backing causes the dollar to fall still more, and inflation feeds on itself. A comparable case would be a corporation that buys calls on its own stock. If the stock falls in value, then the calls lose value. The resulting loss of assets causes the stock to fall still more, etc.

    So not only should the Fed be prohibited from buying bonds directly from the Treasury; the Fed should be prohibited from buying dollar-denominated bonds at all.

    1. What do they call that, a knife-edge equilibrium? It's surprising that we don't see more sudden collapses/spikes in purchasing power given the fact that most central bank assets are comprised of domestic bonds.

      Purchasing inflation-protected bonds like TIPS would provide some stability.

      The problem with prohibiting central bank purchases of bonds is that the bond market is far more liquid than other markets, and central banks need to be able to buy and sell in size.

    2. Nobody has named it yet (Sproul equilibrium? Koning equilibrium?), and yes, TIPS would prevent the feedback effect. Also, the more 'real' assets a bank holds, the more muted the feedback effect. Small central banks can easily avoid the problem by buying US bonds. The Fed, however, should probably stick to TIPS, possibly issued by foreign corporations and governments.

  2. So Reaganomics restricts MMT?