Federal Reserve Notes, Interest, and the National Debt

by Edward Flaherty

Federal Reserve Notes, Interest, and the National Debt

by

Dr. Edward Flaherty
University of Charleston

July 18, 1997

How does currency enter our economy? This is a common question that any curious citizen will eventually ask. Depending on whom they ask, they could get an alarming answer. Some groups claim that the Treasury prints the currency, sells it to the Federal Reserve at tiny fraction of its face value, and that the Fed then buys Treasury bonds with the money -- bonds for which the Treasury must then make interest payments. In effect, then, the federal government is paying interest on its currency to the Federal Reserve system. Conspiracy theorists believe this is part of the New World Order plot to bankrupt the United States. What is the truth here? Does the government, that is, do we really pay interest on our own currency?

Thomas Schauf of FED-UP circulates an information letter in which he writes:

Why pay interest on our currency? A typical incorrect answer is - the FED profits are returned to the U.S. Treasury. The truth is, the FED is a private bank in business for profit. We pay roughly $300 billion in interest on our artificial debt and by special agreement, the U.S. Treasury receives $20 billion in return. Taxpayers lose $280 billion to the FED banking system per year ... Your local library has these dollar figures. The numbers don't lie.

Schauf also argues that the Federal Reserve system is part of the international banking conspiracy, and that President Kennedy might have been assassinated because he allegedly attempted to curb the power of the Federal Reserve ( both of these topics are covered in other essays on my Fed Conspiracy Myth page ). The currency interest issue is also raised by other conspiracy theorists. Television evangelist Pat Robertson in his book The New World Order and Jacques Jaikaran in Debt Virus make identical claims, as do several on-line organizations such as the Coalition to Reform Money and Citizens for a Better Government. How accurate are these claims?

Some of Schauf's statement is correct. The Treasury Department prints U.S. currency and then sells it to the Federal Reserve system for an average cost of about 4 cents per bill. However, the Fed must present as collateral for the currency an amount of Treasury securities that is equivalent in value to the currency purchased. The Federal Reserve collects interest on all the Treasury securities it owns, including the ones held as collateral. But this is as far into the realm of fact as Schauf's statement can take his reader. (For more on how currency enters the economy, see the New York Federal Reserve site)

What Schauf does not tell his reader is that nearly all the Federal Reserve's net earnings must be paid to the Treasury. This is done per an agreement between the Board of Governors and the Treasury. In fact, Schauf goes as far as to say that this is incorrect. Schauf seems to make two mistakes that lead him to an erroneous conclusion. First, he seems to believe that all the outstanding Treasury securities -- the national debt -- are held by the Federal Reserve. This is not true. About 7.5 percent of Treasury bonds, $391 billion as of September 1996, are owned by the Federal Reserve. As shown below, the Fed receives only about $20 billion of the Treasury's interest payments, with the remainder paid to those who own the other 92.5 percent of the Treasury's bonds. Second, he seems to believe that the Treasury only receives a fixed amount of the Fed's annual net earnings. In reality, the Treasury gets about 94 percent of the net earnings, which frequently yields a payment in excess of $20 billion to the Treasury.

These two errors lead Schauf to assert that the Treasury is paying the Federal Reserve about $280 billion each year in net interest payments. This is totally wrong. Let's examine the abbreviated income statements for the Federal Reserve system, audited by Price Waterhouse, for 1994 and 1995 (figures are in billions).

1994 1995

Income: ---------------
Interest on Treasury Securities $19.2 $23.8
Other Income 2.3 1.6
---------------
TOTAL INCOME 21.5 25.4

Payments to U.S. Treasury $20.5 $23.4

Source: Annual Report, 1995, Board of Governors of the Federal Reserve System.

For the two years combined the Federal Reserve collected $43 billion in interest on its holdings of Treasury securities. The Fed also repaid $43.9 billion to the Treasury. Since 1980 the Fed has collected $255 billion in interest from the Treasury, but has repaid a total of $267 billion.

Clearly, the Treasury is not paying any net interest on the bonds held by the Fed, and is therefore not paying any net interest on Federal Reserve Notes. In fact, the Treasury usually profits from this arrangement. Indeed, Mr. Schauf, the numbers do not lie.

Schauf and other similar conspiracy theorists believe that the Treasury ought to issue its own currency in the form of United States Notes, a form of currency issued on a few occasions in the past (there are still some in circulation, although the total amount is limited by law) . This, Schauf, argues, would be an interest-free form of currency. However, clearly there is no functional difference between U.S. Notes and the Federal Reserve notes we now use. Neither impose a net interest burden on the Treasury. The key difference is who controls the issuance of the currency. The publicly-appointed Board of Governors now controls the emissions of Federal Reserve notes, and can make monetary policy decisions independent of political pressure. U.S. Notes, on the other hand, are controlled by the Treasury Department, an arm of the executive branch and a purely political entity. Monetary policy, in my view, ought to be based on the needs of the economy, not on the needs of current incumbent political party.

Another implication of the arrangement between the Federal Reserve and the government is that the bonds held by the Fed are, in effect, interest-free loans to the federal government. As far as the Treasury is concerned, the more bonds held by the Fed, the better, as it reduces the Treasury's net interest burden. In fact, bonds held by the Fed are the equivalent of literally printing money and spending it into the economy. This is because the bonds are interest-free and may be refinanced by the Fed indefinitely. Rather than a loan, most people would call that a gift.

Like the other Fed conspiracy myths, this one has also proven to be false. The federal government does not pay any net interest on the Federal Reserve notes that serve as our currency. The key error of the conspiracy myth-makers, or errorists, is their failure to recognize that the Fed's annual payment to the Treasury almost always equals or exceeds the interest the Treasury pays to the Fed. But such sloppy research, factual errors, and fabrications are par for the course in the world of the Federal Reserve conspiracy theorist.