Greg Mankiw’s exam question

Via Ron Paul and Dean Baker (really):

  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?

My answer is a little different from Greg’s, though without denying he has outlined a possible and indeed plausible scenario (he argues that destroying the bonds is irrelevant and #2 would be contractionary).

I don’t quite view the Fed as a pure Ricardian shell of the government as a whole, at least not for every marginal choice.  So if the Fed has its stock of bonds destroyed, it wishes to recapitalize itself, in part because it doesn’t fully trust the indirect option on recapitalization through Congress and it wishes to restore its financial power base.  It can do this in a number of ways, but the simplest is to print up more money and buy something valuable.  We get QEIII, though on which assets is unclear.  The shadow banking system expands, while the higher reserve requirements (assuming a penalty rate of interest) contract the non-shadow banking system.  Overall that’s a bad mix, though we have temporarily solved the debt ceiling problem.

In the longer run the Fed is more subject to the will of Congress (it required some kind of implicit permission to recapitalize, and thus some kind of deal was struck) and that is probably contractionary after the new QEIII wears off.  Overall, it can be said that when there are agency relationships it matters in whose pocket the assets are stored and thus full Modigliani-Miller neutrality will not hold.

If you’re from Minnesota (I am not), you will start by asking how the destruction of the bonds is done in a “balanced budget” manner or not.  Is an offsetting change in fiscal policy required to maintain a balanced budget constraint, or can we think of the bond destruction as itself an act of fiscal policy?

Returning to the previous track, you might alternatively think that Congress and the Fed cannot cut a deal and, after this policy change, the Fed cannot recapitalize.  In that case the Fed’s “sopping up the expanded monetary base” option is weaker than before, this is viewed as implicit monetary expansion if only probabilistically.  Instead of QEIII we get a probabilistic QEIII.  A boom is boomier because M2 is rising and there is less mopping up, but there is probably less expansion in the more pessimistic scenarios because until there is strong positive pressure on M2 the absence of the mopping up option doesn’t mean that much.

Those are not the only scenarios.


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