We may need a new term for Fed “Profits”

It’s more than semantics to understand what we mean by The Fed’s profits.

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.  Fed BS Dec 2009

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.

By Sherry Jarrell

One thought on “We may need a new term for Fed “Profits”

  1. The same SORT of analysis, in the same SORT of spirit could be extended to much of the derivatives activities by vulgar banks. For example AIG “profits” meant something entirely different from profits, in the usual sense of the term. AIG basically piled up premiums (“profits” as far as the recipients of bonuses were concerned) for some insurance they had no hope to be able to pay, should the housing market go down.

    Most of this year bank “profits” are also probably of the illusory type, for the same reason as Sherry dissected in the case of the Fed above: if one is provided with arbitrary high capital for zero cost (as in the case of the Fed), one can show arbitrarily high “profits” on the interest. Fundamentally, it’s how a Ponzi, pyramid scheme works. Give an individual a billion dollars, and allow him to claim the interest on it as play money, and that individual will be rich. This pretty much abstracts banking today. That is why the real economy is dying (last time I was in the USA, nothing was getting done, everything was dying, including the roads).

    Real profits ought to be connected to real goods and services. Lending people money is a real service, but also an inconvenience, and thus should be compensated with the payment of the revealingly called “interest”.

    But there is a degree of abstraction of the good (for example fancy derivatives)or the service (insuring all of finance 100% against a housing crash) which makes it correspond to nothing real, or can even make the leverage work the wrong way (which is what happened in 2008). Thus all derivatives, and ways to use them, which are not demonstrated safe and effective ought to be OUTLAWED. Think about a Financial Protection Agency, similar in purpose and spirit to the FDA.

    Profits were not invented for metaphysics, but for plain old physics: a help to motivate people to act POSITIVELY on the real world.

    That is why the rescue effort in Haiti is looking exclusively for mental profits having a real physical world impact, and the pecuniary profit motive is useless there, as government forces rush in.

    Patrice Ayme


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