One of the great skits from the days of Monty Python's Flying Circus was the "Stake Your Claim Game Show." The first contestant on this show is introduced as claiming that he wrote the complete works of Shakespeare.
By asking the contestant's age, the host is able to quickly determine that works of Shakespeare were known for several hundred years before he was born. At that point the contestant acknowledges that this is where his claim breaks down and concedes that the host is more than the match for him.
I felt sort of like this contestant when I saw that Greg Mankiw had discovered that Ron Paul's plan to destroy the $1.6 trillion in government bonds held by the Fed (which I endorsed) to get around the debt ceiling was "just an accounting gimmick." Clearly Mr. Mankiw is more than the match for me.
Of course it is an accounting gimmick. We have an accounting problem (the debt ceiling). It cries out for an accounting solution.
However, there is a more serious issue in the second part of the story. If the Fed destroyed the bonds, rather than selling them back to the public as currently planned, it can save the government close to half a trillion in interest payments over the next decade. That sounds like a good deal to me, especially in a context where people are talking about cutting Social Security and Medicare as a way to reduce deficits.
Destroying the bonds would create some problems. The reason that the Fed plans to sell the bonds is to pull reserves out of the system thereby preventing inflation at a point where the economy has recovered. The alternative that I suggest is that the Fed could simply raise reserve requirements to accomplish the same goal.
Mankiw points out that:
"assuming the Fed does not pay market interest rates on those newly required reserves, it is like a tax on bank financing."
This is true. Higher reserve requirements will increase the gap between the interest rate that banks charge on loans and the interest rate they pay on deposits. However, this may be seen as a relatively harmless tax. After all, what's the consequence of people getting 20 basis points (0.2 percentage points) less on average on their bank deposits or paying 20 basis points more for loans?
In any case, this implicit tax seems like the sort of proposal that should be in the policy mix right now. After all, I suspect that most people would consider it preferable to the bi-partisan plans to reduce Social Security payments 3 percent by changing the cost of living adjustment formula.