question:
The U.S. Federal Reserve System differs from most government agencies in two important ways. First, the Federal Reserve determines its own operating budget and sends the remaining proceeds to the U.S. Treasury. Second, the Federal Reserve receives its income from printing money and holding interest-bearing assets, so it has some control over that income. Issuing more currency than is consistent with price stability can increase this income in the short term. However, unlike private corporations, no individual or entity owns the Federal Reserve’s residual income.
(a) Explain how the absence of residual claimants affects the Federal Reserve’s incentives in choosing the size of its operating budget. In particular, discuss whether this institutional arrangement promotes least-cost production methods.
(b) Even if price stability is an official policy goal, explain how the Federal Reserve’s ability to generate revenue through money creation can create an inflationary bias.
(c) Why does transferring excess revenue to the Treasury not completely eliminate these incentive problems?Use basic economic theory to explain.
Solved:
The Fed occupies an unusual position in the system. It sets its own operating budget, which is financed primarily by revenue from assets acquired by issuing currency, and sends whatever is left over to the Treasury. But no individual or clearly defined group owns that residual income. This structure insulates monetary policy from short-term political pressures, but it also raises fundamental incentive issues. In other words, how does an institution behave when there is a shortage of remaining claimants, which could partially impact the institution’s income?
We begin with the absence of residual claimants. In a privately held company, shareholders receive the residual, or net income, after all expenses have been deducted. They require managers to produce a given output at minimum cost in order to earn profits. If a business owner spends too much, profits will decline and the business owner will bear the losses. Competitive pressures and governance mechanisms enforce that discipline.
At the Fed, there is no comparable party that internalizes the benefits of dollar savings. After paying expenses, the Fed transfers the surplus to the Treasury. Therefore, slimming the operating budget does not lead to personal economic benefits for decision makers within the organization.
The logic of public choice predicts that in this situation, managers can benefit from a larger budget (staff, scope, influence, prestige) even if that budget does not maximize efficiency. The Fed’s ability to set its own budget strengthens this trend because it does not have to persuade Congress each year for diversion. That autonomy protects independence, but it also reduces external cost discipline, making owners and occupiers more likely to have leeway than organizations that actively scrutinize their spending.
Now add the features that make the Fed different from ordinary bureaucracies. That means it can affect the Fed’s own bottom line.
A typical agency that wants to spend more will need to acquire a larger budget. In contrast, the Fed derives its income primarily from interest on its holdings. Generating base money allows you to purchase additional interest-bearing assets and increase your total profit. This link between money creation, asset holdings, and revenue gives the Fed partial control over revenue sources. Of course, the Fed cannot do this without constraints. The demand for money and the mandate to maintain price stability limit how far money and assets can be expanded without creating inflationary pressures or political backlash. However, these constraints do not preclude the associated incentives. To the extent consistent with its interpretation of price stability, the Fed can expand its balance sheet and increase its revenue stream to fund operations.
This relationship is important because it interacts with the weak cost control incentives discussed above. In most bureaucracies, budget increases are limited by the need to secure funding even if managers desire a larger budget. The Fed does not require administrators to rely on the same channels. Financial institutions can increase their profits by holding more assets funded by money creation, and with that revenue they can support larger operating budgets. To understand the incentive problem, we don’t have to assume that officials “want inflation.” This problem is structural. The Fed is combining less pressure to minimize costs with a partial ability to expand its revenue base to fund spending.
Finally, consider why transferring excess profits to the Treasury does not solve these problems. Remittances will be made after the Fed chooses to spend them. The Fed first sets an operating budget and then transfers any remaining surplus to the Treasury. The order is important. The remittance requirement does not prevent the Fed from expanding spending in the first place, so it does not impose severe budget constraints in advance. Additionally, there will be no residual claimants within the institution. Treasury officials and taxpayers receive the surplus, but they have no direct control over the Fed’s internal budget decisions, and Congress cannot monitor every margin of spending at no cost. Therefore, the principal-agent problem still remains.
Remittance requirements do not eliminate the Fed’s revenue autonomy. Even if the Fed transfers all residual profits, it still determines the size and composition of the balance sheet that generates gross profits. To the extent that the Fed can coordinate money creation and asset purchases within its mandate, it can influence the resources available to fund its operations. That is, although surplus remittances may prevent private appropriation of profits, they do not restore the incentive properties of residual claims or impose a binding external budgetary process that disciplines regular institutions. Therefore, the Fed remains a unique bureaucracy. They face weak incentives to minimize costs and, unlike most bureaucracies, can partially influence the sources of revenue that finance their budgets.
