The Federal Reserve, it has been reported, earned record
"profits" of over $46 billion in the year ending December 31, 2009.
The previous record profit was $34.6 billion in 2007. The Fed earned
$31.7 billion in 2008. The financial crisis has apparently been very good for
the Fed, although, as a non-profit entity, all its profits are turned over to
the Treasury. As an aside, I wonder what the Treasury plans to do with
its windfall?Reduce taxes? Hmmm.
Be careful, however. "Profits" are a bit of a
misnomer for the Fed's activities, because they pay for what they do by
creating money out of thin air. To buy a financial instrument such a
treasury bill or mortgage-backed security, which is added to the left-hand-side
of their balance sheet as an asset valued at cost, they create (and I do mean
"create," in the true sense of the word) an equivalent amount of
deposits on the right-hand-side of their balance sheet. It does not "cost" them resources as it would you, or me, or a business. The "expense" is deducts from revenues to arrive at this period's profits consist mainly of employee salaries.
So if the Fed purchased a bunch of assets with reserves that they
created, where do the "profits" come from? Keep in mind, there
are two major drivers of profits. One is efficiency, or doing more with
your resources. The second is pricing power, being able to charge an
above-competitive price for a good or service either because you own something
scarce or you make up the rules of the game.
First, two minor sources of income to the Fed are the
interest and fees it charges for operating the financial system, such as check
clearing and interbank electronic payments, and those it charged participants
in the emergency loan programs it undertook to support credit cards and auto
loans.
By far the largest source of revenue to the fed, however, came
from its open market operations and the purchase of toxic assets. The Fed
had about $1.8 trillion in U.S. government debt and mortgage-related securities
on its books by the end of 2009, four times the level in 2008, and the interest
payments it collected on this huge pile of assets generated much of their
(so-called) profits. But interest payments are only one source of returns
on financial assets. The other is "capital gains" or "price
appreciation." If and when the Fed sells these assets, some of them
considered "toxic," there is a real risk that they will incur
significant capital losses. For example, the central bank recorded
a $3.8 billion decline in the value of loans it made in bailing out Bear
Stearns and AIG.
So the Fed’s profits are this period’s interest income minus the
Fed’s minimal operating expenses; the capital base on which it earns income is
basically “free.” And all of these figures focus on one-period accounting
entries, ignoring the huge potential negative stock of value the Fed’s
activities are generating.
Don’t misunderstand. The Fed provides an invaluable service to the
national and world economies, and they generally execute those services very
well. But when they begin to try to act like a business, replacing
existing investment banking with their own activities, and parade around profit
figures as if they meant the same thing as private industry profits, we must step
back and take a moment to understand that Fed profits mean something entirely
different from corporate profits.
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