Myth #4: The Federal Reserve is a privately owned bank out to make a profit at the taxpayers' expense.

This myth claims that the 12 Federal Reserve banks are privately owned and therefore want to earn a profit just like any other company.  Of course, the Fed holds the reigns of monetary policy, so naturally they will use it for the benefit of their owners and not the economy at large.  And finally, since the Fed owns lots of government bonds, much of the Fed's profits come at the taxpayers' expense through the interest paid to the Fed on those bonds.  Like many of the other Federal Reserve myths, this one has a small degree of truth to it, but also has a fair amount of misinterpretation and it leaves out a number of crucial details.

  Organization of the Federal Reserve System

The Federal Reserve System is sometimes described as a quasi-government agency because it contains elements of both the private sector and of government control.  The System has three organization levels: member banks, Federal Reserve Banks, and the Board of Governors.  Let's examine each briefly.

Member banks are at the bottom of the organization chart.  These are commercial banks and S&Ls who have joined the Federal Reserve System (FRS).  By law, all nationally chartered banks must join, and any state chartered bank has the option to join (12 USCA §282).  By joining the FRS a member bank is becoming a shareholder -- an owner -- in its regional Federal Reserve Bank.  For example, suppose you and I open a new nationally chartered bank in Charlotte, North Carolina.  According to the district map, we see that Charlotte is in the Richmond Federal Reserve district, so our new bank will have to become a member of the Richmond Federal Reserve Bank.  So, the claim that the "Fed is privately owned" is correct -- each Federal Reserve Bank is owned by private for-profit commercial banks and S&Ls.

Why are member banks -- the owners -- at the bottom of the organization chart?  They are at the bottom because unlike the shareholders of a typical corporation such as IBM, member banks have very little power over how their regional Federal Reserve Bank is run.  And they have no control at all over monetary policy.  Shareholders of IBM elect the company's board of directors who in turn choose the firm's CEO, so they have a collective say on the company's operations.  Member banks also get to select 6 of the 9 directors of their regional Federal Reserve Bank, but these directors control only the Bank's daily operations, not monetary policy which is the most important function of the Federal Reserve System (12 USCA §301 and 12 USCA §302).

At the middle level in the organization chart are the 12 regional Federal Reserve Banks.  They have a variety of powers and duties, some of which are:

  • Buy and sell government bonds in the secondary markets (open market operations)
  • Lend reserves to member banks
  • Offer check-clearing services to member and non-member banks
  • Issue Federal Reserve Notes and collect worn-out ones for destruction
  • Enforce reserve requirements and other regulations of the member banks
  • Monitor banking and economic activity within their respective district
In terms of monetary policy, the most important power is the first one -- open market operations.  Buying government bonds in the secondary markets increases the amount of reserves in the banking system, puts downward pressure on interest rates, and tends to expand the money supply.  Selling government bonds does the opposite.  This is the monetary policy function that is most often associated with the Fed (What is monetary policy?).  However, a Federal Reserve Bank can only employ open market operations with the explicit approval of the Board of Governors (12 USCA §355).

Finally, at the top of the structure chart is the Board of Governors.  The Board is a 7-member panel who is appointed by the President of the United States and confirmed by the Senate (12 USCA §241).  The Board's current Chair is Alan Greenspan.  Among its responsibilities:

  • Determine open market policies
  • Set the required reserve ratio for member banks
  • Set the Discount Rate
  • Deciding how much new currency to print
  • Monitor the health of the U.S. economy
  • Report to Congress periodically on the state of the U.S. economy
It's single most important duty is deciding its open market policy, that is, whether it should order the Federal Reserve Banks to buy or sell government bonds, and if so, how much.  This decision is made in conjunction with the Federal Open Market Committee.  The FOMC is a 12-member panel can consists of all the Board members, the president of the New York Federal Reserve Bank, and 4 presidents from the other Federal Reserve Banks on a rotating basis.  The presidents are appointed by each Bank's board of directors, pending approval from the Board of Governors (12 USCA §341).

Thus, all the key monetary policy decisions -- the ones that affect interest rates -- are made by a government agency whose members are selected by the President of the United States.  The Fed may be privately owned, but it is controlled by the government.  

The Fed and Taxpayers

The second part of this myth is that the Fed is a drain on the Treasury, and therefore a drain on taxpayers.  This is untrue.  The Federal Reserve Banks are entirely self-financing institutions; they do not receive any tax dollars allocated to them from the federal budget.  Let's take a look at the table below to see exactly where they get their money and how they spend it:

1999 Combined Statements of Income of the Federal Reserve Banks (in millions)

Interest income   Interest on U.S. government securities               $28,216   Interest on foreign securities                           225   Interest on loans to depository institutions              11 Other income                                               688                                                        -------         Total operating income                          29,140

Operating expenses   Salaries and benefits                                  1,446   Occupancy expense                                        189   Assessments by Board of Governors                        699   Equipment expense                                        242   Other                                                    302                                                        -------         Total operating expenses                         2,878

Net Income Prior to Distribution                       $26,262

Distribution of Net Income   Dividends paid to member banks                           374   Transferred to surplus                                   479   Payments to U.S. Treasury                             25,409                                                        -------         Total distribution                              26,262

Source: 86th Annual Report of the Board of Governors, p.335.  

We can see from the top of the table that the Fed's primary source of income is interest from government bonds.  This money is paid to the Fed by the U.S. Treasury.  Is this not de facto evidence the Fed is leaching off the taxpayers?  No, it is not.  The Treasury is obligated to pay interest to whomever owns those bonds.  If the Fed did not own them, then the interest would have been paid to someone else.  In fact, from the Treasury's perspective, it is a good thing the Fed holds those bonds.  At the bottom of the table, we see the Fed makes a substantial annual payment to the Treasury.  The higher the Fed's net income is, the larger the payment to the Treasury.  In other words, the Treasury gets back a significant amount of the interest paid to the Fed.  Thus, government bonds held by the Fed are essentially interest-free loans to the government.  

Conclusion

The regional Federal Reserve Banks are private owned, but they are controlled by the Board of Governors -- a federal agency whose members are appointed by the President and confirmed by the Senate.  The Board sets monetary policy and the Federal Reserve Banks execute it.  In addition, the Fed does not use any taxpayer money to fund its operations.  While the Fed does collect interest on government bonds, the Treasury would have had to make such payment even if they Fed did not hold any bonds.  Moreover, the Fed rebates a significant share of its net income to the Treasury each year, revenues the government would not have at all if the Fed owned no government bonds.  

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