The Platinum Coin Solution

Now that Washington's sturm and drang over the debt ceiling has passed, we can get ourselves ready for the next crisis - raising the debt ceiling. And unlike the poorly methaphorized and intentionally engineered fiscal cliff, this one has actually serious consequences. The United States simply cannot default on its debt, as the consequences would be disastrous, so we're stuck looking for a way out if Washington decides to rush, again, headlong into disaster.

Let's make one thing clear: the debt ceiling is an unbelievably stupid and dangerous idea. Getting rid of it is the best individual action that Congress can take to help ensure American economic security. It wouldn't be that hard to do either. From 1979 to 1995, debt ceiling increases were automatic, following a piece of legislation originally proposed by Dick Gephardt.This was undone during the fiscal brinksmanship of the Gingrich era, and now we're left with an enduring symbol of modern Congressional dysfunction: to achieve very limited partisan ends, House Republicans are willing to enact significant, permanent damage to US economy. It's pathetic.

Obviously, this cannot continue, and the President has already made it clear that it won't. James Pethokoukis at the American Enterprise Institute, quoting Chris Krueger at Guggenheim Securities’s Washington Research Group, summarizes his three basic alternatives to default if Congress fails to come to an agreement over the debt ceiling: increase the debt limit with a resolution expressing Congressional disapproval (the McConnell option); invoke the 14th amendment and continue borrowing regardless of what Congress does; or let the Treasury just create enough new currency to pay the bills on as needed basis. For most, Pethokoukis included, the latter solution seems like one of those "just so crazy that it might work" ideas. As Krueger writes,

This is even more theoretical than the Constitutional Option, though some argue that it is a stronger legal option.  There are limits on how much paper money the U.S. can circulate and rules that govern coinage on gold, silver, and copper.  BUT, the Treasury has broad discretion on coins made from platinum.  The theory goes that the U.S. Mint would create a handful of trillion dollar (or more) platinum coins.  The President would then order the coins deposited at the Fed, who would then put the coin (s) in the Treasury who now can pay all their bills and a default is removed from the equation.  The effects on the currency market and inflation are unclear, to say the least.  You would also likely trigger a wave of lawsuits similar to the Constitutional Option and create two tranches of treasuries.  Both this option and the Constitutional Option are VERY low probability options

As the brilliant Steve Waldman over at Interfluidity points out, Pethokoukis/ Krueger are only partially right: creating platinum coins could eliminate all of the debt ceiling nonsense, but there aren't any economic unknowns in this scenario. In fact, as crazy as it sounds, the Treasury can work with the Fed to resolve the debt ceiling crisis independently, with an effect as if it were simply borrowing. Here's how that would work.

First things first. Just like the trillion-dollar coin idea, the treasury will simply make some new currency and use it to pay its bills after it passes its debt limit. After all, it is within its legal right to create any currency in any denomination as long as it's cast in platinum. A single, trillion-dollar coin is probably a bit risky (what if you lose it?), so the Treasury will probably mint a bunch of million-dollar coins instead.

In short, the government is literally creating the money it needs to pay its bills. Economists call this seigniorage. While the idea seems pretty sweet in the abstract (go go gadget money machine!!!), printing money to pay your bills is a terrible idea, since it usually causes inflation in the absence of external mitigating factors (more on that below). You are creating more currency without actually increasing income. Therefore, your currency, in relation to actual stuff in the economy, is now worth less. Obviously, this can all get out of control really quickly (think Zimbabwe), so it's better not to start running down this path.

A quick aside: we have annual inflation because the Fed intentionally creates more currency than the growth of GDP. Since this inflation is anticipated, it allows us to have price stability. There's also some crazy stuff with how interest rates factor into this issue, which is why, right now, you can have stuff like QE3 create money and not end up creating inflation.

In order to stop the government's money printing scheme from causing rampant inflation, Fed would begin a process of selling the treasuries to make sure that the general currency level remains essentially the same. Since you need to give the Fed some cash to pay for that treasury it's selling, the money you're using to pay is now out of circulation. Think of it like filling a pool with a drain open at one end. As the treasury increases the currency level with its new coins, the Fed will be removing currency by selling the bonds. The technical word for this is sterilization.

Oddly enough, even though this is all technically still seigniorage, the ultimate result would be essentially the same as just issuing debt. Instead of paying interest, the government is sacrificing the interest that it earns for itself by having the Fed sell some of the bonds it owns (yes, the US government pays interest to the Fed which the Fed then pays back to the government; it's weird, I know). Everything would continue as normal as long as the Fed doesn't run out of government bonds. Since it has about three trillion dollars' worth right now, this won't happen for a long time.

And just like that, the debt ceiling is solved.