Sunday, July 03, 2011

A Good Exam Question

Dean Baker endorses and expands upon an idea of Ron Paul's.  I think the idea is crazy, but at least it is crazy in an interesting way.  Here it is, in a nutshell:
  1. According to Congressman Paul, to deal with the debt-ceiling impasse, we should tell the Federal Reserve to destroy its vast holding of government bonds.
  2. Because the Fed might have planned on selling those bonds in open-market operations to drain the banking system of the currently high level of excess reserves, the Fed should (according to Baker) substantially increase reserve requirements.
This would be a great exam question:  What are the effects of this policy? Who wins and who loses if this proposal is adopted?

STOP READING.  Think about the question yourself for a few minutes.


Okay.  Here is my answer:

Part 1 is just an accounting gimmick. Since the Fed is really part of the government, the bonds it holds are liabilities the government owes to itself. Destroying the bonds has no direct economic effect. It is just like an increase in the debt ceiling, without any other policy changes attached.

Part 2 is a form of financial repression. Assuming the Fed does not pay market interest rates on those newly required reserves, it is like a tax on bank financing. The initial impact is on those small businesses that rely on banks to raise funds for investment. The policy will therefore impede the financial system's ability to intermediate between savers and investors. As a result, the economy's capital stock will be allocated less efficiently. In the long run, there will be lower growth in productivity and real wages.