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A Lesson on the Federal Reserve Board and the Deficit

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Written by Dean Baker   
Monday, 20 June 2011 13:45
Let's take this great moment of national deficit hysteria to teach people a bit about the Federal Reserve Board and the deficit. The Wall Street types get very upset when the rest of the country thinks that they should have any influence over Fed policy. But the Fed is part of the government, which means until Goldman Sachs and J.P.Morgan suspend the constitution, the public through its elected representatives can tell Ben Bernanke and the Fed what to do.

One thing that the public could tell Ben Bernanke to do is to hold on to $3 trillion in government bonds and/or mortgage backed securities over the next decade, instead of selling these assets back to the public. This matters hugely for future deficits.

Although you will not hear it discussed in the Washington Post, the Fed refunds the interest it earns each year back to the Treasury. If it hold $3 trillion in bonds that earn an average interest rate of 5 percent a year (the Congressional Budget Office's projected interest rate for the longer term), this translates into $150 billion a year refunded to the Treasury. That would come to $1.5 trillion over a decade.

It is not easy to find spending cuts or tax increases that total $1.5 trillion, but the Fed could accomplish this task just by holding on to the assets it has purchased as part of its quantitative easing programs. To put this number in perspective, this $1.5 trillion in savings would close roughly half of the projected shortfall in Medicare over the program's 75-year planning horizon. That would end a lot of hyperventilating by Republicans who are yapping about Medicare's looming bankruptcy.

There is no obvious downside to the Fed holding onto these assets. The increase in the reserves of the nation's banking system could be inflationary when the economy recovers, but this can be easily countered by raising banks' reserve requirements.

While the Fed rarely uses this mechanism for restraining lending, it is not hard to do. China's central bank has been raising its reserve requirements for the last year and a half. If Mr. Bernanke cannot figure out how to do it, China's central bankers can surely be persuaded to give a quick seminar that will bring him up to speed on the topic.

We are paying an enormous price because the economists who set economic policy over the last decade were too ill-informed about the economy to recognize an $8 trillion housing bubble. The economy and the country will pay an even larger price if it allows the same group of people to continue to set economic policy.

There has to be a discussion of having the Fed hold large amounts of assets - even members of Congress should be able to understand this one.

This post originally appeared on POLITICO's The Arena.

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written by axiom, June 21, 2011 10:35
Don't forget to subtract the interest the Fed pays on reserves.

And that interest bill will increase as the Fed raises the Fed funds rate over the same time period.

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