The blogosphere has already responded in force to Dean Baker’s strange proposal to destroy the $1.6 trillion in Treasuries held by the Fed and use increased reserve requirements to maintain the Fed’s balance sheet once QE is withdrawn. Greg Mankiw poses it as an “exam question”, and rightly observes that the proposal is a mixture of accounting gimmickry and financial repression. (To be fair, the “accounting gimmick” is part of the intent: the idea is to circumvent the statutory debt limit.)
But there’s also a simpler, quantitative problem with Baker’s analysis: he doesn’t seem to have any clue how small required reserves currently are. Let’s take a look:
Currently, banks need to hold only $80 billion in reserves. And that’s in the midst of an ongoing recession, where consumers and businesses have plowed money into liquid assets and, through interest on reserves, the Fed has eliminated the cost of keeping money in accounts with a reserve requirement. Before the spectacular recent increase, the level of required reserves was closer to $40 billion.
The difference between $40 billion and $80 billion, however, is minimal compared to the $1.6 trillion that Baker proposes to capture using a reserve requirement. Currently, the reserve requirement is set at 10% of checking account balances. Even if we increased the reserve requirement to 100%, we’d only be halfway to $1.6 trillion—and that’s under the extraordinarily unrealistic assumption that these balances would stay at their recessionary highs even after a vast expansion in the cost of holding reserves!
How hard is it to get to $1.6 trillion? Let’s say that we broadened the scope of the reserve requirement to cover everything contained in the M2 aggregate: savings deposits, money market deposit accounts, small-denomination time deposits, and retail money market funds. That’s roughly $9 trillion, or $8 trillion after we subtract currency. $1.6 trillion is 20% of $8 trillion. So yes, we can induce a demand for reserves of $1.6 trillion by doubling the reserve ratio and vastly expanding the pool of deposits covered. But even this ignores the fact that depositors would quickly abandon the assets covered by the new requirement, to the point where the total would be far less than $8 trillion.
Of course, if you cast a wide enough net, it’s quite possible to reach $1.6 trillion: US households have almost $50 trillion in financial assets. But you have to ask why this would be a remotely desirable way to raise money. Reserve requirements are effectively a tax on deposits: at the very least, banks are forced to sacrifice the spread between perfectly safe assets (like T-Bills) and reserves (which have traditionally paid zero). Why does Baker think this is a efficient tax? It seems awfully bizarre to me: not only are you taxing savings, which is already inefficient, but you’re restricting the tax to a certain form of savings, which is all the more arbitrary and inefficient. (Not to mention regressive—Grandma’s savings account is taxed while hedge funds are not.)
To be fair, there are serious proposals to use reserve requirements as a regulatory tool, taxing risky liquidity creation to bring it down to the socially optimal level. But to do this properly, you’d need to completely redefine the requirements’ scope: the real risk to the financial system comes from “shadow banking” like repo and commercial paper, not traditional retail deposits. Is this what Baker is proposing? If so, that’s fine—but he certainly doesn’t give any hint of it.