Follow-Up on Ron Paul’s Proposal to Cancel the Fed’s Treasury Holdings
Lew Rockwell wrote a response to my Mises Daily article on Ron Paul’s proposal. I’ll address some of his criticisms one at a time, though not in the order Rockwell listed them:
4. The discussion in the next-to-the last section claiming that Baker’s proposal to raise reserve requirements is tantamount to “stealing money from the banks” is wrong. The Fed has been systematically lowering reserve requirements from almost its inception, permitting the banks to pyramid ever-greater amounts of demand deposits upon their reserves, thus expanding the money supply and fattening their interest incomes. There can be nothing wrong in reversing almost a century of bank thievery.
Yep, mea culpa on my use of the loaded term “stealing.” As Blackadder (I think) pointed out in the comments here when the piece first appeared, it’s a bit weird to say the Fed would be “stealing” when at worst, it would be destroying the banks’ assets without benefiting itself in the process. (So maybe “vandalism” would be more accurate.) And as Rockwell points out, to say “stealing” implies a moral judgment that the banks rightfully deserve the current situation, when I of course don’t believe that.
But here’s what my main point was: Dean Baker (and others) who want to deal with the problem of excess reserves often write as if bumping up the reserve requirement is a painless technical adjustment, akin to turning up the thermostat if you get a little chilly. Yet economically, raising the reserve requirements is almost equivalent to simply erasing the reserves (while keeping the same reserve requirement). It would have sounded crazy if Dean Baker had said, “It’s true, Ron Paul’s proposal will make it impossible to suck those $1.6 trillion in excess reserves out of the system. So to prevent inflation, we can just tell the Fed to turn all those electronic bank deposits into 0s. Problem solved.”
To repeat, Ron Paul, Lew Rockwell, and I don’t think the banks should have been bailed out, and that the insolvent ones should have been allowed to go bust. Therefore, if raising the reserve requirements would effectively crush these big banks, fair enough. My point however was that I don’t think a lot of people recommending “raise the reserve requirements” realize that they would crash the big banks. It would be tantamount to undoing the original bailout.
Rockwell also writes:
3. Also unmentioned: if the Fed is deprived of $1.6 trillion in assets it would have to write down its liabilities by $1.6 trillion to preserve the fiction that it operates like a private institution. And this means that the inflationary excess reserve problem would be solved–the Fed would be forced by accounting rules to simply wipe out the reserve deposits that banks hold with it.
This is really interesting, and I confess I didn’t carry the analysis this far. He’s right, if the Fed suddenly lost $1.6 trillion in assets, it would be technically insolvent. I’m not sure what it would do in that situation. Remember that I had speculated that the Fed’s mysterious accounting rule change was designed precisely to shield it from this sort of problem, i.e. to allow it to move a write-down in its capital to its liabilities instead. (I.e. rather than reducing the liabilities owed to the banks, the Fed under the new rules would list a massive “negative liability” to the Treasury, which it would work off over time as it earned net income.)
2. Unmentioned is the fact that Ron’s proposal would deprive the Fed of the $40-$50 billion per year in interest payments out of which it takes its plush, self-designated budget, returning the rest to the Treasury. It would now have to go to Congress hat in hand for funding like any other government agency.
Well, I didn’t mention this because (as Rockwell notes) most of the interest payments go back to the Treasury. It’s true that the Fed can raise its “costs of operation” without Congressional approval, but on the other hand I think this arrangement benefits the government too. In other words, I think the reason the government likes having the Fed is that it effectively run the printing press to cover some of the fiscal deficit. (I explain that process here.)
To repeat, Rockwell (and Ron Paul) understand exactly what’s going on with the interest payments, but I think a lot of people who initially latched on to the proposal thought it would be immediately saving the Treasury $50 billion per year, and that’s not right. So I didn’t bring it up because it was subtle and I wanted to focus on the other things.
1. “Purists will rightfully object to his classification, because in reality the Fed is a quasi-private entity with private shareholders.” No it is not. (It is not clear whether Bob agrees with this parenthetical statement.) Mankiw is right and the unnamed purists are wrong. The Fed is a government agency, and a rogue one at that, with no Congressional oversight.
Here too, Rockwell and I agree on the basic facts, we are just disagreeing on how to classify the Fed because of those facts. It is not a private agency in the same way that, say, Wal-Mart is. On the other hand, it is not a government agency in the same way that the IRS is. The Fed is nominally owned by private shareholders, and many of its personnel are selected by the commercial banks. Its revenue does not come from taxes, and it has very little Congressional or Executive oversight. However, its leadership is picked by the government, and of course its operations are upheld through the government. So I am calling it a quasi-private organization, you could call it a quasi-governmental one too. Yet I think there is a difference between the Fed’s holding of Treasury debt, versus (say) the Social Security Trust Fund holding government debt.
I am partly stressing this nowadays, because for a long time I took Rockwell’s position and called the Fed a government agency. Yet I was eventually worn down by all the conspiracy theorists who think Big Bankers run the world, and operate above the level of national governments. I am very sympathetic to this view now (in its grand outlines, not in the specifics that all of these guys put forth), and so that’s why I hesitate to treat the Fed as a mere government agency.
I agree that Dean Baker and Bob Wenzel took raising reserve requirements too lightly without really exploring the drawbacks. Matt Rognie has a couple of goods posts on the matter.
http://mattrognlie.com/2011/07/06/required-reserves-much-smaller-than-you-think
http://mattrognlie.com/2011/07/07/avoiding-the-word-tax/
Rognie in the first link makes the incorrect presumption that the 10% reserve requirement is actually being followed.
He identifies required reserves of $80 billion, and then blindly concludes that because required reserves are supposed to be 10%, then he believes total checking and other demand deposit accounts must be Required / 0.10 = $800 billion.
However, if one looks at M1:
http://research.stlouisfed.org/fred2/graph/?id=M1,
Then M1 type money (Notes and coins in circulation, Notes and coins in bank vaults, Federal Reserve Bank credit, traveler’s checks of non-bank issuers, demand deposits, other checkable deposits), then it totals almost $2,000 billion.
These types of accounts are the types of accounts that “should” have reserves backing them, and if THEY acquire 100% reserves, then the $1.6 trillion, i.e. $1,600 billion, owed to the Fed, when added to the existing $80 billion in required reserves already in the banks, would itself not even be enough to back all such demand deposits. So it’s simply not true that $1.6 trillion is way too high. I mean just a naive if then kind of understanding can make this sensible. If the Fed bought at least $1.6 trillion in treasuries, then at least that much money has to be owned by non-Fed entities. Why not back those claims up with actual money?
As for the second link, the idea that raising reserve requirements is somehow a tax is just plain wrong. He writes “The Fed saves money in this scenario only because the new reserve requirements force banks to carry a low-yield asset (reserves) in order to accept deposits.” But that’s not how it works. Banks would just be forced to keep demand deposits on hand and THOSE demand deposits become reserves. That’s not a tax.