Check your math.

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Rand Paul's Know-Nothing Fed Bashing

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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See if you can spot the errors in Senator Rand Paul’s push to audit the Federal Reserve, which he laid out Friday in Des Moines:

“Anybody here want to audit the Fed?” Paul asked from the stage. “Anybody feel that the Fed’s out to get us?” ...

“They’d be bankrupt, they’d be insolvent,” he said. “Liabilities are $4.5 trillion; their assets are $57 billion. Do the math. They are leveraged 80-1. They are leveraged three times greater than Lehman Brothers was when Lehman Brothers went bankrupt. Why do we give ’em a pass? Because they’ve got a printing press, and they can print up some more money.” 

In an earlier version of this post, I mistakenly took Paul to task for referring to “$57 trillion”  in Fed assets, which he hadn't done (he referred to  “$57 billion.”) I am now correcting that error, with apologies. I also removed an erroneous assessment of Paul's definition of bankruptcy, which hinged on my use of “trillion”  instead of “billion.”  

Nonetheless, I stand by my contention that Paul is mistaken in several important ways.

Paul’s main error was in his calculation of the Fed's leverage. Leverage is the ratio of debt to equity. Paul is treating the Fed’s $57 billion of assets -- whatever those are -- as the central bank’s equity. But it’s not.

When the central bank buys assets, it pays for them (mostly) by giving the seller some reserves at the Fed -- basically a checking account. Those reserves are what Paul is referring to when he talks about the Fed's “liabilities.” 

But when the Fed buys assets, on the day it buys them, the value of those assets must equal the value of the reserves the bank swaps for the assets. So the Fed’s “equity,” calculated as total assets minus total liabilities, would then be zero. That would make its leverage ratio not 80-to-1, as Paul contends, but infinite. But that doesn’t make sense.

Paul wants to define “leverage” as the ratio of liabilities to assets. But if that were the case, then the only bank that could have leverage greater than 1 would be a bank with liabilities greater than assets -- in other words, a bankrupt bank. Paul is saying that any bank that uses leverage is automatically bankrupt. That just isn’t true.

A subtler error is in Paul’s definition of the Fed’s “liabilities.” Those are the Fed reserve accounts that I mentioned before. Nowadays the Fed pays a tiny bit of interest on those accounts, but for most of history it didn’t, so let’s ignore that little bit of interest for now. What would it mean for the Fed to “pay back” those debts? Suppose a private bank went to the Fed and demanded money in exchange for its Fed reserves. Nothing would happen. Why? Because Fed reserves are what we use as money. The Fed doesn’t “print up some money” to pay off its liabilities, like Paul alleges. The so-called liabilities are the money it already printed up

So Paul’s call to audit the Fed isn’t based on an understanding of finance. It’s based on emotion.

That makes political sense. There are many people in America who are deeply suspicious of the Fed. There always have been: Thomas Jefferson believed a central bank would rob Americans of their basic liberty, declaring that “the central bank is an institution of the most deadly hostility existing against the Principles and form of our Constitution.” Andrew Jackson made preventing the creation of such an institution one of the mainstays of his political career.

Why does America have this tradition of anti-Fedism? I don’t know, but it seems natural that people would be suspicious of a non-elected institution that controls parts of their lives. The suspicion of the Fed is of a piece with the public's suspicion of all technocrats.

If the Fed can determine the rate of inflation or deflation, people feel that their cash -- which they believe ought to be a safe investment -- isn't so secure. They feel that their life’s savings -- which they worked and sweated so many decades to squirrel away -- are in danger of being confiscated by mysterious faraway elites who don’t even stand for a vote. Who wants that?

What people don’t realize is that inflation and deflation would occur even if there were no Fed. Before 1913, when the Fed was founded, inflation and deflation spiked up and down wildly. The Fed initially didn't stop that behavior. But in recent years, it has adopted a 2 percent inflation target, meaning that it tries to ensure that inflation happens at a slow, steady, predictable rate. That has saved a lot of people’s life’s savings from the sudden swings that used to be common.

Occasionally, though, when the economy is in a recession, the Fed will consider allowing a temporary burst of higher inflation to try to grease the wheels of the economy and reduce unemployment. Whether this tactic works isn't definitely known, though most people believe it has an effect.

But whether it works or not, this kind of intervention, which suddenly reduces both the value of people’s bank accounts and of their debt, naturally stirs up fear that the technocrats are once again dipping their hands into our pocketbooks. That is the fear that Paul is tapping into. His fantasy numbers and mistaken financial concepts are embarrassing, but they are a sign of a real fear that some people still have about the Fed’s intentions.

If the central bank were more open to the public, and made a more concerted attempt to explain what it does, it wouldn't be a bad thing, and it would forestall disastrous blunders by the likes of Senator Paul.

(Corrects references to amount of Fed assets in paragraphs five to 12. Removes reference to bankruptcy in fifth paragraph.)

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor on this story:
Max Berley at mberley@bloomberg.net