Ron Paul's Unusual Proposition

Ladies and gents, Dean Baker endorses a Ron Paul policy idea. No matter the subject, that's always worth sharing. As Baker writes over in The New Republic,

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.

I'm no expert on monetary policy, but there's some interesting debt ceiling theory crafting here. Granted, just like all of the other fantasy intervention scenarios, all of this comes with a giant caveat: we have to assume that the need for an intervention won't spur some form of market panic. We've seen a few times already how these can become catastrophically self-sustaining. Once that threshold is crossed, it doesn't matter what the Fed does.

But let's just assume that won't happen for a moment. Instead, we'll pretend that the Fed has announced with sufficient time before the debt ceiling deadline that it intends to intervene in order to ensure stability in the global financial system. This is totally within their mandate, so people wouldn't be that surprised if the Fed chose to do this. But, surprisingly, they'll announce that they plan on executing the "Ron Paul Plan."

Paul's idea, as Baker happily points out, rests on one of the great paradoxes of modern finance. The Fed is largest buyer of treasuries and by far the largest holder of US debt. All of the principal and interest that the Fed earns is eventually returned to the government. It's weird to think about, but the Fed is actually a profit center. In 2012, it sent 77 billion dollars back to the treasury.

It is totally within reason for the Fed to notify the government that it no longer intends to collect on its bonds. Or, as Ron Paul dramatically puts it, the Fed could "destroy" the bonds that it holds. Either way, this would allow the administration to issue new debt, since the debt ceiling is set at a specific dollar amount. The Fed holds about a trillion dollars in different government securities right now. Cancelling this debt would solve the debt ceiling problem for about a year.

It's an especially nice solution since there is no legal gray area. A bondholder is not legally obligated to collect his or her debt. We never have to deal with this under normal circumstances since everyone does want their money (why else would you buy a bond?). That doesn't change the fact that it is totally possible to just walk away. If the Fed walks away, the government gets a whole new chance to borrow again. Think of it like some giant bureaucratic jubilee.

So what are the consequences? As Baker points out, the Fed uses its treasuries as the key tool in balancing the availability of money and the ability of banks to lend. This is all a part of short-term interest rate targeting. If the Fed wants to reduce the aggregate amount of lending, it sells its treasuries to banks. The banks pay for these treasuries out of their reserves, and the banking system now has less money available to lend.

By bringing up this issue, Baker is taking into account a risk that is normally top priority on the right. All of the Fed's efforts over the last five years have greatly expanded the monetary base, creating the potential for inflation. The Fed's huge reserve of treasuries are insurance against this risk. If the economy grows stronger, and if inflation starts to creep upwards, all the Fed needs to do is sell off some of its bonds, reduce the money supply and cool things down a little.

Baker isn't in the tinfoil hat group that believes we are waiting for hyperinflation. That's normally Ron Paul's gig. Everyone else recognizes that we have far too low of growth to even experience normal inflation right now. This is why the Fed continues to engage in Quantitative Easing, which is nothing more than the Fed buying up all sorts of securities from banks so that they have more money to lend. But that doesn't change the fact that the Fed needs to be on guard against potential inflation in the future, and it needs tools to deal with it.

Without its treasuries, the Fed obviously can play the same game anymore. If inflation were to rise, it would need something to sell in order to reduce the monetary supply. Destroying the bonds that it holds severely reduces its stock of available assets, and it also gets rid of the most typical and liquid asset that the Fed owns. But that doesn't mean that the Fed would be totally helpless.

The Fed has another tool to manage the overall amount of money lent that it tends not to use all that often. As you know, banks are required to hold a certain amount of money in reserve as backstop for all of their outstanding loans. This reserve amount is set by the Fed, and they are the only governing body that has a say in the matter. If it wanted to, the Fed could go out there today and tell banks that they need to hold greater reserves. Banks would have to call in some outstanding loans to meet the new, higher reserve requirement, and this would ultimately have the exact same effect as the Fed selling its Treasuries.

Again, assuming no market panic, this is a totally viable scenario. Despite its source, it actually makes a whole lot more sense and poses way less risk than many of the other schemes proposed. If the Fed destroys its bonds, no other bondholder is affected. They can all collect as before and the "dollar hegemony" can keep on trucking to the next crisis. There wouldn't be a freeze up in lending, nor would the Fed remain powerless to prevent future inflation. The biggest problem I see is that this is kind of a one-off. The Fed wouldn't be able to build up its bond portfolio quickly enough to pull the same stunt again.

There's obviously a legitimacy problem too. What happens the next time Congress refuses to raise the debt ceiling? Unfortunately, very few of possible workarounds solve this problem directly. For that reason, this is all a bit of fantasy. That doesn't mean that it isn't fun.

I hear Congress is trying to offer at least a short-term raise. It should give us about six weeks to come up with other platinum coin kinds of ideas. I don't mind. It's much better than contemplating the apocalypse, that's for sure. Until next time.

Pomp and Circumstantial Evidence

John H. Richardson over at Esquire reports on the comedy, pageantry and tragedy of Ron Paul's Subcommittee on Domestic Monetary Policy and Technology.

So there you have the national debate a nutshell: The Republicans offer folk wisdom, fringe economics, and a continued obsession, two decades after the collapse of communism, with central planning; the Democrats come with statistics and studies but have become too demoralized and feckless to do much more than invoke Milton Friedman. Then a handful of overworked reporters ask a tiny handful of timid questions and rush off to file superficial stories that everyone ignores, leaving Paul to a line of fans led by a white Rasta with a small pamphlet in his hand: 'Will you sign my Constitution, since you're the only one that follows it?'

The government we deserve...

Liquidate the Debt!

Continuing on the discussion of the Gold Standard, we have Ron Paul's statements on debt, the lynchpin to the Gold Standard's failure.



I'm not always sure what Ron Paul means by that, and I'd appreciate better clarification. I often worry that it means defaulting on US debt, since this is what Paul seemed to want during the debt ceiling debate. I believe that would cause a lot more harm than good. Since interest rates continue to be low, even though (or maybe because, causality on this isn't always clear) the US is one of the last developed economies that hasn't dropped back into a recession, the US could borrow and spend its way out of the depression.

That doesn't mean borrow and spend forever. But it does mean doing something other like stopping the 15,000 + government layoffs happening every single month.

The chart is indexed, instead of based on a specific value. Pay attention to the trend. Via Matt Yglesias.

If the Federal government would have stepped in and financed state governments further, we'd have saved the jobs of 1.3 million federal workers. That's more than a percentage point in the unemployment rate.

There's a limit to this, of course. You could say that this would last until the private economy adds an average of 300,000 jobs for 6 months straight. By then, recovery should be well set in.

Like the WWII debt, which was never technically paid off, over a long enough horizon, that debt wouldn't matter too much in the long run. If you finance it at 30 years with the tiny interest rates on long-term US bonds, enough growth and moderate inflation would make it go away. As I've written before, it's debt to gdp ratio that matters most, not the nominal value.

I do believe that private debt overhand continues to be a problem and it is a big problem in many other countries. The Obama administration has tried and failed twice to bring some form of mortgage relief to borrowers. I'd be interested in seeing how Paul would manage to do that, since private debt is obviously a huge depressor on private spending right now.