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Ron Paul recently made (another)
splash among economic pundits with his suggestion that the Treasury simply
cancel the $1.6 trillion in its debt held by the Federal Reserve. Many of
Paul's longstanding critics seized on the proposal as reckless and said it
was further evidence that Paul doesn't understand financial markets. However,
Paul received unexpected praise from the progressive economist Dean
Baker.
In the present article I'll explain
the basics of Dr. Paul's proposal. It's hard to say what its ultimate impact
would be if enacted, because the analysis depends on our assumptions. Even
so, we can sketch some of the main considerations to at least build a
framework for evaluating his suggestion.
Ron Paul's
Modest Proposal
At the 10:00 mark in this interview with radio host Jan
Mickelson, Paul says that one quick solution to the stalled debt-ceiling negotiations is for the
Treasury to simply cancel the roughly $1.6 trillion in its securities
currently on the balance sheet of the Federal Reserve. That would immediately
reduce the outstanding federal debt by the same amount, thus freeing up room
for Treasury Secretary Geithner to continue meeting the government's
financial obligations even without a Congress-approved increase in the
statutory debt ceiling.
Paul argues that this debt
cancellation is acceptable because the Fed just printed up the money out of
thin air to buy the bonds in the first place. In other words, it's not as if
the Treasury would be reneging on its debts held by hardworking, frugal
investors.
Furthermore, Paul briefly mentions
that the move would neuter the Fed's power going forward. After all,
the textbook "open-market operations" through
which modern central banks conduct monetary policy are the buying and selling
of government debt. If the Federal Reserve could no longer trust that the
Treasury would honor its debt once the Fed had acquired it, then the entire
enterprise of US central banking might be jeopardized. For Ron Paul, of
course, that is a virtue of his proposal.
The Critics
As usual, most of the pundits
thought Ron Paul's idea was absurd. Greg Mankiw
thought it was a "crazy" idea that amounted to an accounting
gimmick that effectively raises the debt ceiling by $1.6 trillion without the
trouble of voting on it, while Karl Denninger thought
it was an endorsement of the "raw printing of money," and
"functionally identical to FDR's … gold devaluation."
The first thing to note is that Mankiw and Denninger can't both
be right: Ron Paul's idea can't simultaneously be an accounting gimmick and
a wildly inflationary policy that wrecks the dollar. Even so, let me explain
their (different) points of view.
Mankiw treats the
Federal Reserve as an appendage of the federal government. (Purists will
rightfully object to his classification, because in reality the Fed is a
quasi-private entity with private shareholders.) Therefore, if the Treasury
owes the Fed money, that's basically saying the
government owes itself $1.6 trillion, which is equivalent to saying that the
government owes itself nothing.
However, the practical effect of
such a cancellation — according to Mankiw
— is that the Treasury would free up $1.6 trillion of room under the
current statutory limit on the total outstanding debt that the Treasury can
owe. In other words, if we count the $1.6 trillion in Treasury debt currently
on the Fed's balance sheet, then Geithner is already out of room and he can't
borrow any more. But if we suddenly declare that the $1.6 trillion is no
longer valid debt, then Geithner can go into the markets and borrow another
$1.6 trillion from new lenders. The move would be equivalent, therefore, to
Congress raising the current debt ceiling from $14.3 trillion to $15.9
trillion.
On the other hand, Denninger claims that the move would be a lot worse than
an accounting trick — it would be a severe devaluation of the dollar.
Although he doesn't spell out exactly why this should be so, I think Denninger has in mind something like the following: When
the Fed initially acquired its massive holdings of Treasury debt, it created
new reserves. Currently, the banks aren't granting new loans based on these
reserves, in the manner described by economics textbooks. That's why
"excess reserves" have gone through the roof since the financial
crisis started in the fall of 2008:
 
What Denninger
(and other critics warning about Paul's "hyperinflationary"
proposal) presumably have in mind is that investors continue to have faith in
the US dollar because they believe that Ben Bernanke will suck those excess
reserves out of the financial system when he needs to. In other words, once
consumer prices start rising at an alarming rate, Bernanke would need to
tighten up on monetary policy.
The standard, textbook way for Bernanke
to unwind his extraordinary interventions would be to literally reverse them.
That is, he would sell the Fed's massive holdings of Treasury debt
back into the hands of the public, and in so doing the excess reserves would
shrink back down toward their normal level (near zero). Commercial banks
would then be unable (because of reserve requirements) to create trillions of
dollars in new loans, and the dollar would be spared.
Now we see the potential problem in
Ron Paul's idea. If the Fed no longer has $1.6 trillion in Treasury
securities, then it won't be able to convince people in the private sector to
write checks to the Federal Reserve in exchange for its assets. Therefore,
the Fed won't be able to drain excess bank reserves out of the system.
Possible
Defenses of Ron Paul
I haven't heard Dr. Paul
specifically address these types of criticisms, but here's how he might do
so:
In response to Mankiw,
Paul could argue that yes, his suggestion is a trick to avoid the acrimonious
debt-ceiling battle, and that's exactly the point. If somebody thinks that we
are currently on a trajectory of Republicans winning massive spending cuts,
then Paul's suggestion would give the deficit spenders an easy way out.
"The real inflation occurred when
Bernanke created more than a trillion dollars in money out of thin air."
However, Ron Paul has publicly said
that he thinks the Republican leadership will cave and will raise the debt
ceiling. Furthermore, despite their tough rhetoric, the Republicans won't
actually put a dent in the mushrooming federal debt. Even from the narrow
point of view of minimizing the growth of the debt, then, it's not clear that
Ron Paul's proposal is worse than what would otherwise happen.
Beyond that, Ron Paul's real goal
here is to weaken the Fed. I believe he is offering his suggestion as
a way for legislators to get out of their current budget impasse, when they
wouldn't dream of zapping the Fed in such a way in other circumstances. As
usual, the ultimate object here is probably educating the public rather than
achieving a particular victory. Paul himself says in the interview linked
above that the Treasury won't actually do what he is suggesting. But it
obviously helps his long-term agenda of weakening (or even abolishing) the
Fed to openly discuss something as "radical" as cancelling its
Treasury holdings.
In response to Denninger
and others who worry that the proposal would weaken the dollar, again I would
argue that we need to specify the alternative. I personally think those
reserves are in the banking system to stay, just as I never believed that US
troops would be injected "temporarily" into
Afghanistan and Iraq to deal with the terrorist emergency. Even if we take
Bernanke at his word, I have pointed out elsewhere that in the event of a
new crisis — where interest rates spike and the reserves start leaking
out of the system — then the Fed's assets would take a huge write-down
anyway. In other words, what is currently $1.6 trillion in Treasury debt
might fall to a fraction of that in the event of a dollar crisis.
In light of the above
considerations, I could defend Ron Paul's overall views like this:
"Sure, it's possible that there will be a drop in the dollar's
purchasing power within the next few years. My proposal doesn't avoid that,
but guess what? That drop is inevitable. The real inflation occurred when
Bernanke created more than a trillion dollars in money out of thin air. Once
he handed it over to the big bankers, and in the process financed much of the
government's massive deficits, that move was a fait accompli. At least by
canceling those securities, we make it harder for the Fed to do something
like this in the future, by throwing into question its open-market
operations."
Finally, I want to point out that
having the dollar backed up by gold is qualitatively different from having it
"backed up" by IOUs issued by the federal government. For one
thing, Federal Reserve notes (and banks' electronic deposits with the Fed)
are legal tender, and we truly have a fiat currency. If you turn in a $20
bill to the Treasury or the Fed, they will give you two $10s or four $5s, but
they don't owe you anything besides the US dollar itself.
Furthermore, reflect for a moment
on the absurdity of claiming that Treasury debt "backs up" the
dollar reserves in the financial system. Suppose someone is holding a $100
bill, but he's not sure if he trusts it as an asset. Would it reassure him to
know that somewhere in the vaults of the Federal Reserve there is a piece of
paper issued by the US Treasury promising to pay a $100 bill in the future?
In short, if someone thinks the US
dollar is a worthless asset, then that person will also think US Treasury
debt is a worthless asset, because it's nothing but a promise to pay US
dollars down the road. This has nothing at all to do with the classical gold
standard, in which the bearer of US currency could exchange it for a
completely different asset, namely gold.
An Unlikely
Ally
Although his motivations are
decidedly different, Dean Baker defended Ron Paul's proposal. In
order to deal with the problem of excess reserves and their potential to
cause high price inflation down the road, Baker suggested that the Fed simply
raise reserve requirements.
In other words, rather than
eliminating the excess reserves by having the Fed
Robert P. Murphy
Essay originally
published at Mises.org here. With authorisation
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