This also works for state and local governments who are supposed to be largely independent of federal influence. For example, when the federal government wanted Idaho and other states to raise their drinking age from 18 to 21, and when it wanted Alaska to reverse its legalization of marijuana, it threatened to withdraw highway funds from these states. Since losing these funds would have been a huge revenue hit neither state could withstand without severe difficulties, they cooperated and changed the laws.
The Federal Reserve system is supposed to be independent from Congress for the most part, and in order to prevent Congress from using the power of the purse to influence monetary policy and other decisions, the Fed is allowed to fund itself from its monetary policy actions.
How does it do this? When the Fed changes the money supply, it does so by buying and selling government bonds or other financial assets. For example, when the Fed buys a bond, it gives newly created money to the owner of the bond to pay for it. That increases the amount of money in the hands of the public and increases the quantity of bonds held by the Fed.
The bonds that the Fed purchases earn money for the Fed in three ways. First, the Fed receives the scheduled interest payments on the bonds. Second, the Fed realizes capital gains and losses on the bonds it holds. Third, if bonds reach maturity while the Fed is holding them, it receives the repayment of the principal along with the interest that is due.
In normal years, i.e. prior to the crisis, the Fed buys and sells government bonds (i.e. government debt) almost exclusively and typically earned around $18 billion per year. The Fed takes all of its operating and other expenses out of this, and at the end of the year anything left over is returned to the Treasury and taxpayers.
As the following graph shows, the amount the Fed earns each year has been rising since the onset of the crisis, and yesterday it was announced that the Fed earned a record $45 billion in 2009 (these are net of operating expenses, i.e. an estimate of what the Fed will turn over to the Treasury).
Why were the earnings so much higher than usual? There are two reasons. First, the quantity of bonds the Fed purchased increased significantly, so part of it is simply a volume effect. Second, the mix of assets changed as the Fed used the TARP program to take risky (toxic) assets off of bank balance sheets, i.e. the Fed began buying private sector bonds in addition to its usual purchase of government bonds, and some of those assets appreciated significantly.
Felix Salmon at Reuters notes that if the earnings were paid out to Fed employees, they would do quite well:
Essentially all that $45 billion was earned by one profit center, the New York Fed... Let's be conservative and call it $21 billion. The New York Fed has 3,000 employees, which means that the bonus pool would work out at $7 million per employee: a full order of magnitude greater than the equivalent number at Goldman Sachs.However, as Felix observes, perhaps the payments aren't fully justified since it doesn't take a lot of skill to make money if you are allowed to print it. If I could print money, buy government bonds, and then keep the interest payments, I could make money too (though the toxic asset component of the purchases was a bit more risky). Ezra Klein says:
"the Fed's earnings for the year will dwarf those of the large banks, easily topping the expected profits of Bank of America, Goldman Sachs and J.P. Morgan Chase combined." The money here is mostly coming from an aggressive policy of buying bonds to lower interest rates, and given that the Federal Reserve can get money for nothing, the yield on those bonds is pretty much pure profit.
That money is going straight back to the rest of the government, which makes sense. On the other hand, I can't help but wish the Federal Reserve would take a quick lesson from Wall Street and hand out some fat bonuses, or maybe some serious raises. It wouldn't be the worst thing in the world if some of the bright young things who flood into investment banks each year thought hard about going into central banking instead -- particularly if we're really going to expand the Federal Reserve's power and make it into a much more aggressive regulator.That's a good point. If we don't pay regulators their opportunity cost, i.e. if we don't pay them what they could earn in the private sector, then few will choose to work for the government and the balance of talents will not be equal. If the Fed wants to match private sector talent, it has to be willing to pay for it.
In any case, that the Fed is earning more than expected is good news. They will likely still end up with net losses once all is said and done since the bailouts of automakers, Fannie, and Freddie are likely to end up in the red, and it may be holding securities that have lost value, but those losses won't be nearly as large as some expected.