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The Danger behind the Fed's Exceptional Profits

Mises Daily: Thursday, January 28, 2010 by

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A few days ago, the Fed announced that it had "earned" a record-high amount of money in 2009. Then it turned $46 billion over to the Treasury. Here we are in the midst of a serious recession, with the unemployment rate high, the housing market still in a slump, and the stock market making only small steps toward recovery. In this climate, the Fed is making profits.

That's impressive, isn't it? Unfortunately, the Fed's huge earnings are a signal that the economy is still in terrible shape and that its condition is worsening.

Let us take a closer look at the Federal Reserve's balance sheets, at least to the extent that they are available to us. One year before reaching their record-high profits, the Fed's assets consisted of nearly $500 billion in government assets. These consisted of Treasury bonds and assets issued by Fannie Mae and Freddie Mac, the two giants of the real-estate market whose solvency is guaranteed by the federal government. Since Fannie and Freddy are currently owned by the state, their assets should be treated as state securities.

During 2009, the Fed was engaged in aggressive interventions in the financial markets; through various operations, it increased the amount of state assets in its possession to $1.8 trillion. The amount of government assets on the Fed's balance sheet more than tripled. With this huge increase in assets held, $46 billion is merely a 2.5 percent return, which was provided directly by the government.

Therefore, the Fed's so-called "profits" are not a sign of the coming of a great revival for economy. They rather mean that a "Keynesian trick" has hid the decline in economic welfare. This trick is often referred to as a "policy mix" — a mixture of fiscal and monetary policies.

Here is how it works. The newly elected President Obama increased the budget deficit to a record high. The Treasuries for that debt are released to the "free market." At the same time, the Fed started its open-market operations, i.e., printing money and buying public debt in order to put it on the balance sheet. Then, when this debt approached maturity, the state paid the Fed for the issued debt (instead of paying to the private investors).

But that is not all. Contrary to the claims of some groups, the Fed is not a private bank: it cannot keep the profits earned from holding public debt. Over 90 percent of the money that the Treasury pays the Fed goes … back to the Treasury. Thus, the modern state receives earnings from printing money while giving a small fee to its financial intermediary.

"From the market point of view the Fed is a bankrupt institution."

Here, in a nutshell, lies the whole mystery of the modern "print on demand" scheme. There are no free lunches, but there are lunches being paid for by somebody else.

Some news agencies claim that the Fed's profits show that taxpayers did not lose money as a result of the massive bailout programs. However, the facts are that Fed earned the money through government securities. When the government does pay the Fed in order to boost its "earnings," the money safely returns to the government.

Thus, the government and the central bank can show profits ad infinitum by endlessly pouring money from the Treasury's account to the Fed's account and vice versa. Or better yet, the Fed can pay the Treasury several times more by printing trillions of US dollars, buying companies on Wall Street, and achieving small dividends.

Thus, the so-called "profits" are not evidence that the US economy is doing well. Far from it, these profits are proof that the printers are working long hours. Moreover, the state took upon itself huge liabilities, which call into question the solvency of the entire American financial system. It makes the hypothesis of a return of high inflation more probable (although this scenario is currently still less likely than further "deflation" of the credit).

We should use this opportunity to touch upon a different problem, the accounting rules for the Federal Reserve. Unlike most financial institutions, the Fed does not comply with the "mark to market" rule, the principle according to which, in case of assets losing their value, the books need to be revalued in order to reflect the market price.

If the securities issued by Fannie and Freddy and bought by the Fed suddenly declined in value by 50 percent, the Fed would not need to book the losses on these assets. This mechanism makes the central bank not only a lender of last resort but also a market creator of last resort.

The question arises, what might happen if the Fed was faced with the need to resell the assets in order to increase interest rates or stop inflation.

Then we may find out that the Fed would not be able to sell these securities at the booked price. To convince the private banks to buy them through open-market operations, it might need to reduce the price. Then the Fed would have no other choice than to record the actual losses. This could even result in the Fed reaching negative equity.

If it came to this, there are two possible scenarios. In the first, the central bank would be recapitalized by the Treasury. This would be an interesting scenario, in which the power to tax would support the power to print, not the other way around. In the other scenario, since nothing precludes the Fed from having negative equity — it's not a private company, traded on the stock market — there would be no consequences. It might well continue its operations without any noticeable difference.

But wouldn't that mean a collapse of the dollar? The value of liabilities would be much higher than the value of assets, while the dollar would not even be covered by state-issued bonds.

In either case, one thing is certain: from the market point of view the Fed is a bankrupt institution. History provides an example of a currency backed by a phony real-estate market: French assignats, which ended up being completely devalued.

The only thing keeping the Fed alive is the protective umbrella of the American state and its legal-tender laws. This is not a parasitic relationship but a symbiotic one. What remains to be seen is how strong this symbiotic bond is and how long it will take to succumb to unavoidable decay.