POLITICS JULY 2, 2011
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Representative Ron Paul has hit upon a remarkably creative way to deal with the impasse over the debt ceiling: have the Federal Reserve Board destroy the $1.6 trillion in government bonds it now holds. While at first blush this idea may seem crazy, on more careful thought it is actually a very reasonable way to deal with the crisis. Furthermore, it provides a way to have lasting savings to the budget.
The basic story is that the Fed has bought roughly $1.6 trillion in government bonds through its various quantitative easing programs over the last two and a half years. This money is part of the $14.3 trillion debt that is subject to the debt ceiling. However, the Fed is an agency of the government. Its assets are in fact assets of the government. Each year, the Fed refunds the interest earned on its assets in excess of the money needed to cover its operating expenses. Last year the Fed refunded almost $80 billion to the Treasury. In this sense, the bonds held by the Fed are literally money that the government owes to itself.
Unlike the debt held by Social Security, the debt held by the Fed is not tied to any specific obligations. The bonds held by the Fed are assets of the Fed. It has no obligations that it must use these assets to meet. There is no one who loses their retirement income if the Fed doesn’t have its bonds. In fact, there is no direct loss of income to anyone associated with the Fed’s destruction of its bonds. This means that if Congress told the Fed to burn the bonds, it would in effect just be destroying a liability that the government had to itself, but it would still reduce the debt subject to the debt ceiling by $1.6 trillion. This would buy the country considerable breathing room before the debt ceiling had to be raised again. President Obama and the Republican congressional leadership could have close to two years to talk about potential spending cuts or tax increases. Maybe they could even talk a little about jobs.
In addition, there’s a second reason why Representative Paul’s plan is such a good idea. As it stands now, the Fed plans to sell off its bond holdings over the next few years. This means that the interest paid on these bonds would go to banks, corporations, pension funds, and individual investors who purchase them from the Fed. In this case, the interest payments would be a burden to the Treasury since the Fed would no longer be collecting (and refunding) the interest.
To be sure, there would be consequences to the Fed destroying these bonds. The Fed had planned to sell off the bonds to absorb reserves that it had pumped into the banking system when it originally purchased the bonds. These reserves can be created by the Fed when it has need to do so, as was the case with the quantitative easing policy. Creating reserves is in effect a way of “printing money.” During a period of high unemployment, this can boost the economy with little fear of inflation, since there are many unemployed workers and excess capacity to keep downward pressure on wages and prices. However, at some point the economy will presumably recover and inflation will be a risk. This is why the Fed intends to sell off its bonds in future years. Doing so would reduce the reserves of the banking system, thereby limiting lending and preventing inflation. If the Fed doesn’t have the bonds, however, then it can’t sell them off to soak up reserves.
But as it turns out, there are other mechanisms for restricting lending, most obviously raising the reserve requirements for banks. If banks are forced to keep a larger share of their deposits on reserve (rather than lend them out), it has the same effect as reducing the amount of reserves. To take a simple arithmetic example, if the reserve requirement is 10 percent and banks have $1 trillion in reserves, the system will support the same amount of lending as when the reserve requirement is 20 percent and the banks have $2 trillion in reserves. In principle, the Fed can reach any target for lending limits by raising reserve requirements rather than reducing reserves.
As a practical matter, the Fed has rarely used changes in the reserve requirement as an instrument for adjusting the amount of lending in the system. Its main tool has been changing the amount of reserves in the system. However, these are not ordinary times. The Fed does not typically buy mortgage backed securities or long-term government bonds either. It has been doing both over the last two years precisely because this downturn is so extraordinary. And in extraordinary times, it is appropriate to take extraordinary measures—like the Fed destroying its $1.6 trillion in government bonds and using increases in reserve requirements to limit lending and prevent inflation.
In short, Representative Paul has produced a very creative plan that has two enormously helpful outcomes. The first one is that the destruction of the Fed’s $1.6 trillion in bond holdings immediately gives us plenty of borrowing capacity under the current debt ceiling. The second benefit is that it will substantially reduce the government’s interest burden over the coming decades. This is a proposal that deserves serious consideration, even from people who may not like its source.
Dean Baker is the co-director of the Center for Economic and Policy Research. His most recent book is False Profits: Recovering from the Bubble Economy.
24 comments
Sort of. But if it requires congressional approval, nothing has changed. And there is no practical difference between raising the debt ceiling with this debt ostensibly outstanding and lowering the debt outstanding by canceling it in order to create space under the existing debt ceiling, except that the Fed loses some flexibility in managing the money supply.
- roidubouloi
July 2, 2011 at 12:04am
Yes, but does Lindsay Lohan approve this proposal? http://www.tnr.com/blog/jonathan-chait/91193/lindsay-lohans-right-wing-monetary-views . . . I'll show myself out.
- Konstantin
July 2, 2011 at 3:29am
The Fed is independent of Congress, so I guess the Fed could do this. However, since Ron Paul wants to dismantle the Fed (so very Jacksonian is Paul), I would like to know more about the unintended consequences inherent in any Ron Paul idea. malahat: have you read William Greider's "Secrets of the Temple"? history of the Federal Reserve Bank. excellent read, am thinking it is time to read it again, 20+ years later.
- K2K
July 2, 2011 at 9:49am
Glanced at those wiki pieces linked by malahat. One one technical point, I think they are incorrect. It says that the Fed does not use adjustments to the reserve ratio to manage the aggregate of bank liabilities because it would cause liquidity problems for banks with low reserves. This is wrong. There are always banks with low reserves because there are lots of variations in the liability structures of banks. This is why the Fed Funds market exists. Banks with excess reserves lend them to banks with shortfalls in reserves. This serves the systemic function of keeping the system as a whole integrated and in balance. It is in some sense one big bank with individual franchises. Unless the reserve ratio were adjusted to the point where the system as a whole were short of reserves, the Fed could use the reserve ratio to sterilize its own issuance of high-level money (reserves with the Fed). The reasons why adjustments to the reserve ratio are little used are several. One is that it is rather gross in its effects. With open-market operations, buying and selling Treasury securities, the Fed can make what it thinks of as "fine" as well as temporary adjustments. Whether these fine adjustments really matter is the subject of argument, but it is a part of what they think they are doing. Also, they can make adjustments this way without sending a big public signal. Adjustments to the reserve ratio are read as an indication of monetary policy and thus trigger secondary market reactions, including changes in interest rates that would not necessarily occur from the same reduction in money supply achieved through open market operations.
- roidubouloi
July 2, 2011 at 11:13am
I know the formula, malahat, but there really is no difference in terms of the ratio between bank deposits and reserves between withdrawing the reserves by open market operations, whichptio makes them disappear from the banking system and reduces the maximum level of bank deposits permittd, and supporting the identical quantity of bank deposits by changing the ratio between existing reserves and the deposit base you want. Simple algebra. The only differences are in the mechanics of getting there and the public perception, including the desire not to have a reserve requirement that is stated to six decimal places for small changes. I also neglected to mention the speed of adjustment. With an open market sale of Treasuries, bank deposits vanish immediately. With an adjustment tonthe reserve ratio, it has to work it's way rough the credit system and constrains growth in money rather an extinguishing money. Part of why reserve ratio changes are likely to have more of an effect ons interest rates.
- roidubouloi
July 2, 2011 at 12:27pm
Work it's way through the credit system
- roidubouloi
July 2, 2011 at 12:29pm
I looked and the authority of the fed to simply surrender treasuries to the treasury or lend them to the treasury is unclear at best. It cannot sell or repo them directly to the treasury as that is prohibited. There fed could give them over to the treasury in exchange for circulating Treasury notes, the old style money which was a Treasury liability rather than a Federal Reserve liability. But as far as I can tell the issuance of such money is limited to $300 million as they stopped raising it when Treasury money was withdrawn from circulation. I do think the Fed could buy a couple of hundred million of gold from the Treasury but I think the US gold supply is already owned by the Fed. Best move, as I have said, is to keep writing checks and have e Fed honor them. Or, the Treasury could even make deals with some big banks to do so with an offer to redeem them later at a premium. This has some problems that would not arise if the Fed just honored the Treasury checks as I think it is clear it has the power to do.
- roidubouloi
July 2, 2011 at 12:40pm
Couple of hundred billion of gold. Sorry about that.
- roidubouloi
July 2, 2011 at 12:41pm
Yup. Some months ago I wrote that the American right is now populated by enemies of the nation who are willing to do us intentional harm to secure political power for themselves. A number of our more rightwing posters scoffed (and worse). When do I get to say, I told you so? Now?
- roidubouloi
July 2, 2011 at 4:28pm
too right malahat - it should be an automatic assumption that anything said by Ron Paul that even obliquely references the Federal Reserve Bank of the U.S. is meant to undermine the Fed's existence. Ron Paul should stick to legalizing marijuana, as long as that includes "sin taxes". Having just discovered yesterday that one outcome of Massachusetts' RomneyCare is that primary care providers are VERY well trained as to what is covered and how it is coded, at least for basic Medicare, it is astonishing that the Democrats think they can use MediScare. Trust me, as of 2011, Medicare as we know it is already rationing care to a level where I wish they would just give me the Death Pill so I can take it when my savings run out, which will be about the time both sides of the aisle play chicken on the debt ceiling without recognizing that the Capitol Follies undermines CONFIDENCE, and nothing else matters. The only difference between US currency and a blank sheet of copy paper is CONFIDENCE that the currency paper has value.
- K2K
July 2, 2011 at 6:43pm
Well, K2K, I am sorry about your health problems, and I also agree that Ron Paul’s proposal isn’t meant to keep the Federal Reserve in good odor. However, if you don’t think there is a fundamental difference between the Democrats and the Republicans on health care, then you haven’t lived in a Republican ran State. Whatever your problems with the health care system in Mass you should magnify them by 150% if you want to know what it’s like in any Republican ran state in the South or Midwest. After your savings will run out in your state there is a pretty decent health program called Masshealth which should kick in. with your medical expenses. Of course, I don’t know your exact financial situation so I am not sure how it will affect you. Still, given the medical-financial predicament you say you are in, I don't know why you would support the Republicans at all.
- arnon
July 2, 2011 at 8:25pm
thanks malahat and arnon. The irony of my current medical straitjacket is that has nothing to do with what is slowly killing me, conditions for which there is NO cure or fix. But, I also happen to have osteoarthritis in my neck, and at times, both of my arms go partially numb. My right shoulder/arm is much worse since the winter of snow shovelling. I wanted one MRI of my neck and both shoulders, but, after three months of trying to get this, finally was told that Medicare will never cover such an MRI. Instead, I have to do the right shoulder, then maybe the neck, and then the left shoulder. Three separate MRIs, because of Medicare constraints. I dropped out of the Rx plan three years ago because of the constraints. To be blunt, I would prefer being able to have the CHOICE to get what I need, and pay for it all out of pocket at rates that are not RETAIL, which I do when I have the rare voice consult with my shrink because Medicare will not cover voice consults, which constrains where I can live because of that location. I am not a typical person because most of my health problems are the direct result of medical/medication mistakes by some of the best doctors in the New York metro area. I now refuse to EVER enter a hospital again for ANY reason. Just never get around to tattooing "Do Not Resuscitate" on my chest. I have paid for LongTermCare insurance since 1990, but really wish I could just decide when to end life, on my terms. The Democrats wasted their window of one party rule on health insurance reform that has further divided the country while implementing rationing into basic Medicare as of January 1, 2011. Obama does not care about anyone over 50, and both parties are hostage to rotten-divorced-from-reality ideologies. if I could, I would move to Finland, only sane nation in the world. Any time I vote for the Republican since 2008, it is solely a protest vote. I still vote in New York, but might be forced to change residency in 2012 to Massachusetts due to the never-ending housing crisis (which I blame the Dems for), and I am looking forward to actually voting FOR Scott Brown. I also think Gov Deval Patrick is the only Democratic governor doing a good job, but I dread having palestinian-loving Olver as my congressman. But, my vote in New York in 2012 might carry more weight...well, at least it will not be Ron Paul on the ballot!
- K2K
July 3, 2011 at 11:26am
There is another possible route to avoiding financial armageddon, but it too requires the cooperation of the Fed. There is a provision of law that, in an emergency, permits the Treasury to borrow directly from the Fed: 31 USC § 5301. Buying obligations of the United States Government (a) The President may direct the Secretary of the Treasury to make an agreement with the Federal reserve banks and the Board of Governors of the Federal Reserve System when the President decides that the foreign commerce of the United States is affected adversely because— (1) the value of coins and currency of a foreign country compared to the present standard value of gold is depreciating; (2) action is necessary to regulate and maintain the parity of United States coins and currency; (3) an economic emergency requires an expansion of credit; or (4) an expansion of credit is necessary so that the United States Government and the governments of other countries can stabilize the value of coins and currencies of a country. (b) Under an agreement under subsection (a) of this section, the Board shall permit the [Federl Reserve] banks (and the Board is authorized to permit the banks notwithstanding another law) to agree that the banks will— (1) conduct through each entire specified period open market operations in obligations of the United States Government or corporations in which the Government is the majority stockholder; and (2) buy directly and hold an additional $3,000,000,000 of obligations of the Government for each agreed period, unless the Secretary consents to the sale of the obligations before the end of the period. (c) With the approval of the Secretary, the Board may require Federal reserve banks to take action the Secretary and Board consider necessary to prevent unreasonable credit expansion. ____________________ One would have to take a look at the legislative history to figure out just what this is all about, but the language is probably adequate on its face, particularly the phrase "notwithstanding another law," such as the debt ceiling. $3 billion a day is roughly the rate of the deficit, but the language is ambiguous as to whether this can cumulate or whether it is a $3 billion aggregate cap on direct borrowing. Or it might permit the Fed to by $3 billion a day and sell it in the open market. Again, one would have to look at the history to see whether the needed interpretation is an acceptable interpretation. This provision may be as antiquated as the debt ceiling itself. __________________ Good luck K2K. I do hope there is something that can afford you relief and years more than you currently anticipate.
- roidubouloi
July 3, 2011 at 1:00pm
K2K “The irony of my current medical straitjacket is that has nothing to do with what is slowly killing me, conditions for which there is NO cure or fix. But, I also happen to have osteoarthritis in my neck, and at times, both of my arms go partially numb. My right shoulder/arm is much worse since the winter of snow shovelling. I wanted one MRI of my neck and both shoulders, but, after three months of trying to get this, finally was told that Medicare will never cover such an MRI. Instead, I have to do the right shoulder, then maybe the neck, and then the left shoulder. Three separate MRIs, because of Medicare constraints. I dropped out of the Rx plan three years ago because of the constraints. To be blunt, I would prefer being able to have the CHOICE to get what I need, and pay for it all out of pocket at rates that are not RETAIL, which I do when I have the rare voice consult with my shrink because Medicare will not cover voice consults, which constrains where I can live because of that location.” Again, K2k, I am sorry about your condition, but there is a doctor in this house and I told that your wish to have “one MRI of my neck and both shoulders, but, after three months of trying to get this, finally was told that Medicare will never cover such an MRI.” Isn’t forbidden by Medicare. If were told that you need separate MRI that was a medical and not a Medicare decision. I hope you can get to Finland someday, K2K. Check out their tax payer supported health care system: “The separate private health care system is very small. Between 3 and 4 per cent of hospital in-patient care is provided by the private health care system and the remainder by the public system.” http://en.wikipedia.org/wiki/Healthcare_in_Finland
- arnon
July 3, 2011 at 1:30pm
arnon: after three office visitss since January, focus on the death-inducing conditions, and a letter begging for a referral to a specialist in between, I have no choice but to follow what my current primary care provider says about Medicare coverage for MRIs. Of course it makes no sense and maybe she is wrong, but I have nowehere else to go. My previous PCP dropped out of Medicare in 2007. Medicare is already broken, and the new constraints effective 2011 are really depressing. and, I once worked for a Helsinki-based company, in their NY office. When they downsized me for being too old (age 48), I had to explain what had just happened to my Finnish boss, who was hysterical at having to be part of my being fired. She did not understand such blatant discrimination. I never could learn the language, but I am very well aware of all the strengths of Finland, except for their curious aversion to public laundromats :) BTW, most of the medication/medical mistakes by so many premier doctors happened when I had gold-plated employer-provided medical insurance. The problem is not insurance, but the way that medicine is "practiced" in America. I would rather go to a Druid witch these days.
- K2K
July 4, 2011 at 9:36am
All I can say, K2K is that is my own experiences and the experiences of people I know (some of which include medical practitioners) were and are very different. I am sorry you are having so much difficulty getting the medical attention you need. Anyway, whatever your problems I doubt the Republican medical plan would help and it would make medical treatment a nightmare for a lot more people.
- arnon
July 4, 2011 at 10:33am
malahat I wrote you a note on thread about missing Harold Koh.
- basman
July 4, 2011 at 3:08pm
arnon I wrote a further comment on the thread about Bulger regardless of having "signed off."
- basman
July 4, 2011 at 3:40pm
k2k I sorry to hear about your medical issues, any other issues nowithstanding.
- basman
July 4, 2011 at 3:42pm
Good luck K2K. Life sucks and then you die. Hope to keep benefiting from your thoughts as long as you put them out there. Ron Paul deserves credit for an active mind in the intellectual desert of Congress. Bob
- Robert Powell
July 4, 2011 at 6:19pm
This can't work for the simple reason that most of the Fed's holdings of Treasury securities are pledged to secure its note issues. If you look at one of the bills in your wallet, you'll notice it says "Federal Reserve Note." The face value of each of these notes is a liability of the issuing Reserve Bank, which by law must be fully collateralized by Bank assets. According tho the Fed's annual report, at the end of 2010 the 12 Federal Reserve Banks together held $1.066 trillion in Treasury securities, of which $925 billion was pledged to secure their note issues. So for the Fed to return these securities to the Treasury for cancellation would require the Fed to recall 98% of the U.S. currency in circulation. Of course, Congress could amend the Federal Reserve Act to remove the collatel requirement, turning Federal Reserve notes into unsecured liabilities, but then you run into a different problem. Taking a trillion dollars off the asset side of the Reserve Banks' collective balance sheet would require a corresponding debit to the other side. Their biggest liability is deposits (i.e., reserves held at the Fed by the nation's banks, $968 billion), followed closely by Federal Reserve notes in circulation ($941 billion), then funds held for the U.S. Treasury ($239 billion); you couldn't reduce any of these liabilities. That means the Fed would have to take a charge against capital, but the Reserve Banks collectively have only $53 billion in capital, so writing off their Treasury holdings would put them over a trillion dollars in the hole. What do you think of an insolvent central bank? Me neither. Paul, of course, is a crackpot and may actually want to have to Fed declared insolvent as a way of getting rid of it, but that doesn't mean that we should buy his schemes.
- linjoco
July 5, 2011 at 9:57pm
Although the collateralization of Federal Reserve Notes with Treasury securities is a fiction, I believe linjoco's description of the law is correct and explains why Fed has no authority simply to surrender its Treasury securities for cancellation. As to the fictional aspect, one cannot secure one's obligations with but more of one's own obligations, and both the Fed and the Treasury are part of the Federal government. Moreover, with what does the Treasury pay its obligations? Federal Reserve Notes or Federal Reserve account credit. The Fed takes Treasuries out of circulation and issues its own notes in their stead. The Treasury takes Federal Reserve notes or credits out of circulation and uses them to pay off its securities.
- roidubouloi
July 6, 2011 at 12:33am
It's not that simple. We all tend to think of the Fed as a single government agency, but in fact it's a system consisting of 14 separate units: 2 government agencies (the Board of Governors, which oversees the system, and the Federal Open Market Committee) and 12 Federal Reserve Banks. Each Reserve Bank is a corporation that is owned not by the govermnent but by its shareholders. Reserve Bank stock is not like normal corporate stock: it's not publicly traded, you or I cannot own Reserve Bank stock, certain banks are required to buy Reserve Bank stock and they're not allowed to sell it, so they don't have the same degree of control over the Reserve Banks as normal shareholders have over the corporations they invest in, but as a technical these banks are the owners of the Federal Reserve Banks. Treasury securities are held not by the Board or the FOMC, but by the Reserve Banks, so the federal government does not own the Treasury securities held by the Fed and it's perfectly legitimate for the Reserve Banks to pledge Treasuries to secure their own liabilities.
- linjoco
July 7, 2011 at 9:24pm
Wouldn't the impact be the same if the Social Security Trust Fund destroyed all of its intragovernmental bonds? Stay with me here: 1. Suppose SS runs a $100 billion surplus. It pretends to loan the money to the rest of the Government. In return for the fake loan, the rest of the Government issues SS an intragovernmental bond in the sum of $100 billion. SS is deemed to have $100 billion in its trust fund and the national "debt" goes up by $100 billion even though that $100 billion is not publicly held debt. 2. Now, we get to a year in which SS runs a $100 billion deficit. It turns in its intragovernmental bond for redemption. The rest of the government now has 5 choices (remember the number): A. It can redeem the bond by raising general taxes. B. It can redeem the bond by cutting general spending. C. It can redeem the bond by borrowing from the public and issuing real bonds. D. It can decide not to redeem the bond and can instead raise SS taxes. E. It can decide not to redeem the bond and can instead cut SS benefits. It has to employ one or more of the five options as long as it gets to $100 billion. None of the options is unconstitutional and none is a default on the public debt of the United States as defined by Article 1, Section 8 or by the 14th Amendment. Now, suppose that SS runs out of bonds. Or they burn in a fire. Or Congress cancels them. SS runs a $100 billion deficit. What happens? SS goes to Congress (sans the bond) and says "We need to come up with $100 billion." And now, Congress has exactly the same five options, in exactly the same amount - there's no "bond" involved but Congress still has to decide whether and in what sums to raise general taxes, cut general spending, borrow money from the public, cut SS benefits or raise SS taxes. It's true that the existence of the bonds, under current law, creates a default position if SS runs out of bonds or Congress refuses to redeem the bonds - benefits are cut. But the prospect of cutting benefits has exactly the same political consequences if there are bonds as if they're aren't. Ultimately, we still have to figure out how to get our spending in line with our revenues. But I think we need to re-think the notion that we have government "trust funds" with their "surpluses" in intragovernmental bonds that constitute part of the "national debt". The actual, real debt is the debt owed to the public. The rest is nothing more than numbers on balance sheets and political - not legal or constitutional - obligations. The "crisis" in Social Security, Medicare, etc. is unrelated - completely - to the so-called "exhaustion" of the "trust funds" (whether they are exhausted over several years or simply canceled). The "crisis" exists in every year in which one of these programs runs a deficit - and the crisis is in the amount of that deficit. The world the day, the year and the decade after these trust funds are exhausted will look exactly the way it did the day, the year and the decade before - Congress being politically pressured to deal with whatever the yearly deficit is.
- JACKA
July 23, 2011 at 9:05pm