After $82 billion profit, Is It Still Time to End the Fed?

During the financial crisis, America’s rage against rescuing the collapsed banking system loomed large. That’s understandable since we had a chance to witness first-hand the return on Wall Street’s $5 billion investment in Washington politicians and lobbyists during the decade preceding that collapse. When Wall Street’s highly leveraged bets on bogus mortgages wiped out its capital, the free market was repealed.

Instead, we witnessed reverse-Robin-Hood at its best -- $23.8 trillion in government cash and guarantees – including billions in taxpayer funds funneled to pay Wall Street bonuses.

But it’s turning out that all those bailouts are paying off. When you take into account the Fed’s $82 billion in profit from those bailout deals, it’s beginning to look like the taxpayer will actually make a profit after bailing out history’s worst financial crisis. How did the Fed make that profit? And does this mean that Ron Paul is right that it’s time to end the Fed?

Beginning in March 2008, when it facilitated the merger of Bear Stearns with JPMorgan Chase, the Fed's balance sheet nearly tripled from around $900 billion to nearly $2.6 trillion. The Fed became the garbage dump for Wall Street's toxic waste along with some other debt that was created to stimulate the economy in the wake of the financial crisis.

The Fed donated its $82 billion in 2010 profit to the Treasury Department. And according to the New York Times, that profit came from interest earned on its investments financed through free money. Here are the biggest sources: 

• $45 billion came from its $1 trillion in mortgage-backed securities that it took on in order to keep mortgage cash available -- the MBS yielded about 4.5%
• $26 billion in interest on its $1.1 trillion in government debt -- to which it will add $600 billion in 2011 as part of its so-called Quantitative Easing 2 (QE2) plan to stimulate growth -- the debt yields 2.4%
• $3.5 billion from the $30 billion Maiden Lane subsidiary it created to buy assets from Bear Stearns and American International Group -- it yielded a whopping 11.7%.

It is beginning to look like history will judge the coordinated efforts of the Treasury Department and the Fed during the financial crisis as the most brilliant piece of government bailing out in history. As I posted, the bailout has cost the FDIC only $8.89 billion and the Troubled Asset Recovery Program (TARP) is expected to cost only about $25 billion by the latest count. If you added in a portion of the Fed's profit, the U.S. might end up breaking even or even earning a profit on its bailout. This pales in comparison to the $220 billion price tag for cleaning up after the deregulation of the S&L industry in the early 1990s -- a far less perilous crisis. 

The Fed was originally set up to fight the financial fires created by our unique system of finance that inevitably creates excesses of exuberance and terror. Although it was late to recognize the problem -- noting until the fall of 2007 that the damage from subprime mortgages was contained -- in retrospect, it's clear that the Fed performed quite well during the 2008 crisis.

But Ron Paul (R-Texas), who heads a congressional committee that oversees it, wants to end the Fed. According to Reuters, his latest effort to accomplish this goal is based on his claim that the Fed weakens the dollar and causes inflation. His remedy is to replace the Fed with a gold standard.

I firmly believe that Ron Paul is wrong about this and I am comforted that he lacks the political support to put his ideas into effect. Why? As I've posted, inflation remains low -- despite spiking food and energy prices -- because of downward pressure on wages. And while gold is a popular religious totem, actually using it to control money supply would result in massive economic contraction as the world adjusts to the imbalance between the low supply of gold and demand for the shiny metal.

While it was far from certain that any of the government's intervention would work in 2008, the simple fact is that it has done so. I would be delighted to see a change in our economic system that would minimize the need for the Fed's role as bailer-out-of-last-resort. Doing that would require eliminating the ability of banks to take government-guaranteed deposits and lend them out to risk-taking traders and real estate developers.

Since that little change is not imminent, the Fed has again proved itself to be doing its job well. I am all for political entertainment -- and Ron Paul provides plenty of it. But I just wish the American taxpayer did not need to foot the bill for his circus sideshow.