The recent news that the Federal Reserve made some $14 billion on sundry lending and securities purchases over the past two years is raising comments. It should not.
The Fed usually makes money by managing our nation’s money supply. So do central banks in other countries. Most reports also note that this accounting is incomplete and does not include returns on money the Fed committed to the bailouts of specific companies like Bear Stearns and AIG, which are likely to be losses.
Virtually all accounts, however, miss the central point that gains or losses by the Fed as a result of its actions to stabilize the economy in the financial market debacle of 2007-2009 are of only minor importance to the public that the Fed is supposed to serve. The key question is whether Fed actions prevented a more serious recession that would have cost the public enormous amounts in lower incomes and even greater declines in asset prices.
The fact that news media find much news in the Fed making minor operational profits exemplifies the widespread misunderstanding of the purpose and functioning of the central bank.
Central banks do a lot of things, but the function that makes any of them a central bank is that of creating and destroying money so that the nation’s money supply matches the needs of its economy. Indeed, the opening lines of the Federal Reserve Act of 1913 describe it as a bill “to provide for an elastic currency.”
But central banks need concrete mechanisms to increase or decrease the money supply. They cannot just wave a wand over a fuming cauldron and say “Shazam!” The Fed uses two such mechanisms.
First, it makes loans to commercial banks that are short of cash because the legitimate credit needs of their communities exceed loanable deposits or because a bank has made bad loans that would otherwise bankrupt it if not for loans from the Fed. The money the Fed lends does not come from anywhere else. The Fed simply creates it, either as additional Federal Reserve notes or, most commonly, by simply adding to the balance in the recipient bank’s reserve account at the Fed.
This direct “discount window” lending to banks is what Congress had in mind when it established the Fed nearly a century ago and was the dominant policy tool for the first few decades of the central bank’s existence. When the Fed makes more such loans, it expands the money supply. When it cuts back and makes fewer new loans than old ones being paid off, it contracts the money supply. Loans usually are made only to banks but in “unusual and exigent circumstances,” the Fed may loan to virtually any business.
The Fed eventually discovered that it also could change the money supply by buying and selling government bonds. When it buys a bond, the Fed, in effect, writes a check on itself. The seller of the bond gets a check and the bank in which the check is deposited gets its reserve account credited by the Fed. But the money comes out of nothing, not from any other bank. Since the Fed buys and sells bonds in regular bond markets along with other investors, this tool of altering the money supply is termed “open market operations” and is now the most common tool.
The Fed earns interest on its loans and bonds as would any other lender or investor. Since the Fed had some $800 billion of such loans and bonds on its books before the current crisis arose in 2007, it earns tens of billions of dollars per year even in normal times. From this income, it funds its operating expenses and pays the commercial banks that joined the Fed system a fixed 6 percent dividend on their stock in the Fed. The rest is simply turned over to the Treasury.
So while the Fed lending that is producing some Fed profits is unusual, the fact that it makes profits is not. Nor is the disposition of such profits any dark secret. All 12 district banks are audited each year, currently by Deloitte and Touche, and publish annual reports in paper and on the Internet. The Fed also publishes its balance sheet on a weekly basis.
© 2009 Edward Lotterman
Chanarambie Consulting, Inc.