The question of whether the Federal Reserve made a profit is of much less importance than the per capita consumption of snails in Paducah, Ky. So I was disappointed this month when I heard a long news story on the radio playing up the Fed's $45 billion profit in 2009. This sort of misunderstanding of the Fed's purpose decreases the economic literacy of the country rather than raising it.
The problem with the Fed profit story is that the purpose of any central bank, including the Fed, is fundamentally different from that of any for-profit commercial bank that takes deposits and makes loans. That difference renders "profits" or "losses" completely irrelevant.
A commercial bank exists so its owners earn a profit from the bank's business as a financial intermediary. Society as a whole benefits from these credit and payment services. If a bank fails to make profits over an extended period, it will go broke and its owners will lose their investment.
A central bank exists to manage a nation's money supply, to foster stable prices and provide the preconditions for economic growth and full employment. The Fed cannot by itself make the U.S. economy grow or unemployment fall. But if it fails to do its job, the economy certainly will be hurt. Competent central banking is a necessary, but not a sufficient, condition for prosperity.
Central banks manage the money supply and interest rates by creating and destroying money as needed. They get new money into circulation by buying up government bonds and paying for them with bank reserves that did not exist before. These bonds pay interest, that the Fed, as their owner, collects. Since the Fed holds a substantial quantity of bonds as part of its ongoing operations, it usually earns much more in interest than it spends on its own operations.
In theory, the Federal Reserve district banks are private corporations owned by the private commercial banks that chose to join the system after it was created in 1913. They own shares of "stock." This, one might think, means that these owners would benefit from high profits.
But unlike stockholders of private, for-profit corporations, Fed stockholders don't get to split up profits. They get a small fixed "dividend" payment per year regardless of the size of the system's "profits." The rest gets turned over to the U.S. Treasury.
Fed officials like Ben Bernanke, the other Fed board members and the 12 district presidents absolutely should ignore the question of profits or losses as they decide how to manage the money supply and thus interest rates. They should avoid allowing either inflation or deflation to occur. Period.
Yes, the Fed made a profit this year, because in its emergency efforts to keep the economy from collapsing, it bought up lots of bonds and other financial instruments that pay interest. But the resulting profit has nothing to do with whether these policies were prudent. It says nothing about their success or failure.
Some of the securities the Fed bought and some of the direct loans it made to banks or other financial institutions such as AIG are worthless. Eventually, they will have to be written off. Then the Fed will show a loss. But that loss similarly will tell us nothing about whether the Fed did the right thing in these emergency operations.
The measure of success will be how well the economy recovers from the mess we got ourselves into and how well we avoid the opposing perils of inflation or deflation. The rest doesn't matter at all.