So I have been having a back and forward with Matt Rognlie on his blog about Dean Baker’s proposal to destroy the 1.6 trillion dollars in the Fed balances as a way of avoiding the debt ceiling limit. Note that, as Dean says, this debt is owed by one branch of government to the other (although the Fed is a hybrid part public, part private), and is basically owed to itself. The point is that nobody loses if the Fed just shreds the bonds. Dean then discusses the risks of doing it, which are fundamentally associated with the loss of the bonds (which the Fed could sell to the public to reduce liquidity) and the effects that it might had in future monetary policy. The fear was (although I doubt that was Dean’s concern) the Fed would have its ability to curtail liquidity limited and that inflation pressures might not be contained. Dean simply noted that reserve requirements could be used in that case.
Not a difficult point to make. Rognlie suggests somehow that this is both confusing and not serious. To prove it he assumes that the Fed would need to reduce liquidity by the same amount of the bonds destroyed (and, hence reducing almost the whole increase in liquidity that the Fed was forced to do as a result of the crisis), which he notes would be impossible. The question is why would someone assume something like that, and the only explanation is that he must believe that there is a fixed relation between liquidity and prices (a fixed velocity of money) and that to avoid inflation the same amount of money that was created will have to be destroyed. But that seems to be a very strong assumption to make. Since there is a lot of unused capacity it is far from clear that the Fed needs to increase the reserve requirements at all. So in all fairness there are NO consequences of destroying those bonds. And, as noted by Dean, yes it is just an accounting gimmick to get around the accounting stupidity of the debt-ceiling. It might not have a chance in the current policy debates (since Democrats have a tendency to cave on almost anything), but is a perfectly logical solution.