Ted Cruz’s Fed new plan is a massive distraction

You can count on Senate Republicans to find pointless budgetary gimmicks to avoid talking about serious deficit reduction. In an interview last week with CNBC, Senator Ted Cruz floated the idea that the Federal Reserve should just stop paying interest to banks to save taxpayers money. Budget squeeze solved, easy peasy!

Here’s Cruz: The Federal Reserve pays banks interest on reserves. For most of the history of the Fed, they never did that. But for a little over a decade they have. Just eliminating that saves $1 trillion...

While Cruz wouldn’t handicap the odds that such a proposal would make any headway, he went on to say that he and his colleagues had a serious discussion about the matter just a day earlier. He told Bloomberg News that he had made the case directly to the president as well. It’s alarming that the senators would entertain such a reckless proposal.

Much like Elon Musk’s Department of Government Efficiency, the idea comes from the belief that there are simple and painless ways to rein in the budget and curb interest payments. The premise of the Musk boondoggle was that there were large and obvious savings to be had if only the dumb Democrats had known where to look.

Also in the category of magical budgetary panaceas are several of the proposals put forth last year by then-forthcoming Council of Economic Advisers Chair Stephen Miran, including the notion that the US could basically bully other nations into helping it term out its debt.

Elon Musk

A third example of this phenomenon is Treasury Secretary Scott Bessent’s idea that we can grow our way out of all our problems: We can just make economic output expand faster than most economists think possible and shrink debt-to-GDP that way!

Enter Cruz with the latest distraction from the serious business of the budget. Of course, it’s true that the Fed pays interest on bank reserves and that it’s a relatively modern development. But how it affects taxpayers is rather complicated, since the Fed is generally self-funding. In normal times, it makes money from its asset portfolio and remits the excess to the Treasury. Since it expanded its portfolio when rates were low and is now paying out interest at relatively high rates, the Fed has been posting operating losses. It isn’t remitting profits to the Treasury, and it won’t resume doing so until it’s generating profits again and has made up for past shortfalls. But that should rectify itself with time and lower short-term borrowing costs.

A version of this arrangement has existed since 2008 (except it was previously known as interest on required reserves, or IORR, and some of the particulars are slightly different). But the Interest on Reserve Balance, or IORB, isn’t some sort of sketchy corporate charity to banks, as Cruz has hinted. It’s a tool to exercise control over short-term interest rates to achieve Fed policy goals. Prior to the financial crisis, the Fed would buy and sell securities to increase or decrease bank reserves with the goal of manipulating interest rates — a so-called corridor system. But that system only really worked in a world of scarce reserves.

The Fed’s response to the financial crisis included injecting a large amount of money into the system and bank reserves became abundant to the point that the old system wouldn’t really work anymore. To maintain control over rates in this new world, the Fed started paying interest on reserves, essentially setting a benchmark for market interest rates — an arrangement known as a floor system. Banks knew that they could always, at a minimum, earn whatever the Fed was paying.