Transcripts of the monetary policymaking body of the Federal Reserve from 2002–2008.

Thank you. First, I do really appreciate all the excellent work the staff has done on this topic. I really learned a lot from these papers. I thought they were very clear and very comprehensive. I have just a couple of comments on the questions that Bill and Brian raised in the memo. The first one has to do with whether or not we agree with the objectives, and I do have a couple of issues.

First, I think that the stated objective of reducing the burdens and dead weight losses associated with the current reserve tax is too narrowly framed in the paper. My starting point is, about burden, that to cover a given program of government spending, the Treasury has to obtain revenue from some source, and nondistortionary lump-sum taxes are not one of the available options. So the real question from the public finance standpoint is what to tax and how much. That means, to my mind, that the issue here is how the magnitude of the welfare gains that would come from lowering the dead weight loss due to the implicit tax on reserves compares with additional dead weight losses that would result from the alternative taxes that would have to be raised to make up for this lost revenue. Now the answer depends in part on the interest elasticity of demand for reserves, I believe. I think it is the case that, if the interest elasticity is relatively small, the dead weight loss from the reserve tax is relatively small, and the net welfare gain, taking into account the burdens of raising other taxes to make up for the lost seigniorage, in effect, could easily turn out to be negative.

Let me give you an example of where this comes into play. There is a well-known paper by Martin Feldstein in which he looks at the benefits of moving to price stability, zero inflation, which he favors. He looks at this issue in that context, and he concludes that there would be net social losses, not gains, from the reduction in seigniorage that would be associated with a move to zero inflation from positive inflation because the dead weight loss due to the shoe-leather cost, also known as the Bailey effect, is smaller than the dead weight losses that would be associated with alternative taxes. In his analysis they are taxes on labor supply and saving. I actually think that this is a serious problem with the framing of the objectives in this paper. It is, in effect, saying, “We think we should give a tax cut. We think we should give it to banks, and we think that, because there is a welfare loss—a Harberger triangle—associated with that, this is clear welfare gain.” Now, I am not pretending to know exactly how this would come out, but I do think that’s the issue. If it were to come out that this is a net loss, not a gain, a possible implication is that if there were a fallback to option 1—I’m not saying that I favor option 1— there could be a case for paying no interest on required reserves rather than paying interest at the federal funds rate but paying interest on excess reserves at some rate that we would determine.

There are administrative costs with having voluntary target balances, and it seems to me that the paper, as we come out with it, ought to try to at least estimate what the administrative burdens associated with options 2 and 5 would be.

Another comment on the issue of objectives: If we are coming out with a white paper, it seems to me that the objective that everybody is now discussing and that was just discussed— namely, that paying interest on reserves would enable us to expand the size of our balance sheet in times of financial crisis, like now, and perhaps greatly enhance the scope for liquidity-altering interventions that would be possible without having to push the federal funds rate to zero—is a real improvement in the tool kit that is available to us to address market disruptions. I would see it as an advantage of paying interest on reserves. If you are discussing this right now with the Congress and it is much discussed in the press, I think it is kind of odd to come out with a paper that doesn’t even mention it. Maybe there are disadvantages and not just advantages. But it seems to me it should be there.

Also, I would just say on the question of options 2 and 5 versus options 3 and 4, an advantage that the paper attaches to having voluntary targets is the ability to moderate the volatility in the federal funds rate. So it does seem to me that—I understand it may be difficult—the possibility of intervening multiple times during the day as an alternative, if it were possible to change the procedures so that there could be multiple interventions to reduce volatility, would mean that 3 and 4 could be on the table, and there might be less burden associated with those. So I think that possibility deserves at least careful consideration.

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