I have a new way to balance the budget. When employees are paid, I will require their income to spend one day in an escrow account, where it will be invested in “Liberty Bills”. Liberty Bills are government-issued bonds with a daily return of negative 5%. I am confident that this simple reform will eliminate the deficit.
Of course, you might argue that I’m effectively just hiking income taxes by 5%. You’d be right! “Escrow accounts” and “Liberty Bills” are just a needlessly complicated way for me to impose an income tax. Only someone incredibly naive would think that my policy was substantively different from an income tax, right?
Maybe not. In fact, I see similar proposals all the time.
Consider the following: when Dean Baker proposes that we cancel the Treasury debt held by the Fed, he’s essentially saying (aside from the temporary accounting gimmick) that we should undertake a long-term shift in the composition of debt, from bonds to money. Why? Most observers suspect that the Fed will eventually pull back the money created through quantitative easing. To so, however, it needs to sell lots of assets—and if half of its assets disappear, this is no longer a viable option. Under Baker’s proposal, then, the Fed will be forced to leave over $1 trillion in excess reserves in the system, until it recapitalizes through profits (far in the future) or is bailed out by Congress (in which case the proposal is completely circular). Debt that would otherwise be issued by the Treasury will be left in the form of money instead.
What happens then? Quite possibly nothing. With so many reserves in the system, the premium on reserves will linger around zero—no one will sacrifice yield to hold reserves when equivalent riskless assets are available. The rate paid on reserves, the federal funds rate, and the short-term T-bill rate will all be roughly the same. In this environment, issuing debt in the form of money rather than bonds is completely useless: you can borrow at the same rate with T-bills. Monetization changes nothing.
What Baker proposes, however, is to vastly increase the burden of reserve requirements, such that there is no longer an excess supply of reserves. At this point, banks are willing to pay a premium for reserves, the Fed is able to pay interest on reserves at a rate lower than the rate on T-bills. Money becomes a cheaper form of finance than bonds, and we see a fiscal benefit.
But what’s really happening? 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. In other words, the Fed is taxing bank deposits. In fact, Congress could impose precisely the same tax through legislation: a statutory tax of (federal funds rate – interest on reserves)*(reserve requirement) would be equivalent.
Of course, hardly anyone* wants us to enact an ad-hoc tax on certain types of bank deposits: it’s not a very efficient way to raise money, and it’s quite possibly regressive. I can easily think of a dozen more effective ways to boost revenue. So why does anyone take this proposal seriously? As far as I can tell, it’s because a “reserve requirement” doesn’t sound like a tax. It’s not obvious that this policy is just another distortion-inducing way to gather revenue, and that it should be subject to the same cost-benefit analysis as any tax. As with many proposals for means testing, we’re so eager to escape uncomfortable fiscal tradeoffs that we invent a new, needlessly circuitous way to tax, one that’s even less efficient than the existing tax code.
I’m still fond of Liberty Bills myself.
*As I mentioned in my last post, there are serious proposals for taxing “liquidity creation”, but properly implementing these proposals would produce a policy so different from today’s reserve requirements that it’s a stretch to use the same name.