Congressman Ron Paul (R-TX) is apparently proposing that the U.S. Treasury simply refuse to pay interest and principal on the $1.6 trillion in Treasury securities currently owned by the Federal Reserve. Dean Baker, Greg Mankiw,
Steve Williamson, and
Stephen Gandel all seem to think it’s not a totally crazy idea. Here’s what I think they’re missing.
Steve Williamson frames the question as follows:
Now, to work through this, consider two alternative scenarios. First, suppose that, in the absence of Paul-default, the Fed holds the Treasury debt it has acquired until maturity. In this case, clearly Paul-default cannot make any difference. Without Paul-default, the Treasury makes the payments on the Fed’s Treasury holdings to the Fed, and the Fed sends those payments back to the Treasury. With Paul-default, the net flow between the Fed and the Treasury is the same: zero.
Here we need to distinguish between the Fed’s income statement, which keeps track of its profit or loss, and the Fed’s balance sheet, which keeps track of its assets. It is true that the Fed routinely turns over its income to the Treasury. It is not true that the Fed routinely turns over its assets to the Treasury.
Holding an asset to maturity does not generate an income flow equal to the asset’s par value. Maturation just means that the asset is replaced with another (cash) of equivalent value, a transformation that generates no income. What would actually happen under Williamson’s first scenario, if the Treasury were to retire the debt held by the Fed when the bonds reach maturity, is that the Treasury would have to debit its account with the Fed by the amount of the maturing principal. The funds in that account in turn would have been collected from taxpayers– when they wrote checks to the IRS, those checks were cleared by debiting the Federal Reserve deposits held by the taxpayers’ banks and crediting the Treasury’s account with the Federal Reserve. The net result, if the Fed were to hold the securities to maturity, would be that tax receipts would be used to retire the reserves that the Fed initially created when it originally bought the Treasury debt. In the normal course of affairs, if the Fed holds Treasury securities to maturity, upon maturity total reserves would contract.
What Williamson has in mind with his first scenario is not the Fed simply holding the debt to maturity, but instead the Fed rolling over its holdings of Treasury securities in perpetuity. In this case, his analysis would be correct. Each month the Treasury makes a payment to the Fed (which counts as the Fed’s income), and each month the Fed returns that income to the Treasury (which counts as an offsetting Treasury receipt). This transaction is a complete accounting wash, and it would be entirely equivalent if both the Fed and the Treasury simply agreed to cancel the obligation. The correct conclusion is that, if the Fed intends to allow the $1.6 trillion currently held as Federal Reserve deposits by private banks to remain as currency or reserves on which it pays no interest forever, then there would be no need for the Treasury to think of the Treasury securities held by the Fed as something for which it ever needs to raise taxes to repay.
But of course the issue is that the Fed does not intend to allow the $1.6 trillion to remain forever as zero-interest reserves or turn into currency. If they did, that would mean more than doubling the currency in circulation and would certainly be highly inflationary. We haven’t seen inflation from the Fed’s reserve creation because most people understand that the Fed is never going to allow those reserves to become currency in circulation. Congressman Paul has been asserting that the Fed’s actions already have produced inflation, a claim for which I see no evidence. But the congressman’s latest proposal would help improve the quality of his forecast considerably.
Congressman Paul’s position seems to be that he never approved of the Fed’s purchases of U.S. Treasuries, so why should taxpayers have to sacrifice to pay back the Fed? The key point to remember here is that it was the Treasury, not the Fed, that initially decided to borrow these sums. Any time Congress spends more than it takes in as taxes, it is imposing a commitment on future taxpayers to make up the difference. The taxpayers owe that money whether the Fed buys the securities or not. The Fed made a determination that by temporarily holding a greater portion of that Treasury debt than usual, it could alleviate some of the suffering and waste that results from unemployment and idle production capacity. Reasonable people can and do disagree about the extent to which the Fed’s measures were helpful for that purpose. But that has nothing to do with the commitment on future taxpayers to pay the bill for the previous decisions of the U.S. Congress and President. That commitment was made when the Treasury first issued the securities, and that commitment did not change when the Fed bought those same securities.
Now, in fairness, Dean Baker is not endorsing the proposal of a starkly inflationary outright default, but instead proposes preventing the reserves from becoming currency in circulation by simply requiring banks to hold onto the reserves. I give this part of Greg Mankiw’s answer to his exam question a grade of A+:
Assuming the Fed does not pay market interest rates on those newly required reserves, it is like a tax on bank financing. The initial impact is on those small businesses that rely on banks to raise funds for investment. The policy will therefore impede the financial system’s ability to intermediate between savers and investors. As a result, the economy’s capital stock will be allocated less efficiently. In the long run, there will be lower growth in productivity and real wages.
it would almost certainly be inflationary… but down the line at the point the Fed needed to drain the reserves. We have not seen inflation from reserves creation, not because banks expect the reserves to be withdrawn, but because reserves are sitting unused due to low loan demand (duh, we are in a liquidity trap, people!) So I doubt this would be inflationary now. But if it is, even better, it would be exactly what we the people need! For once… I think Ron Paul has a great idea!
Interesting.
Part one of Mankiw’s answer is exactly correct but that is Ron Paul’s point. The congress does not need to increase the debt ceiling because the FED can serve the same purpose. And that would give congress time to act responsibly in getting the budget under control without increasing the debt ceiling. Sorry, I realize that mentioning “responsibily” and “congress” in the same sentence is a little foolish.
Part two is even more interesting. Mankiw is making the case that FED manipulation in the money market creates problems. Any FED monetary manipulations results in inflations and deflations. This means that FED monetary policy“… will therefore impede the financial system’s ability to intermediate between savers and investors. As a result, the economy’s capital stock will be allocated less efficiently. In the long run, there will be lower growth in productivity and real wages.”
Not a huge revelation. Many of us have been making this case for a long time.
I agree with you on the accounting aspect of a potential Federal Reserve Treasuries Annihilation (TA). But I do not see why TA should imply a greater risk of too high inflation. Couldn’t the Federal Reserve control inflation by raising or lowering the interest rate on private sector central bank deposits (“reserves”)? Is it your view that a TA of $1.6 trillion would not just make the Federal Reserve technically insolvent but also extinguish its economic net worth if it were constrained by a 2 percent annual inflation target?
You’re right that Paul’s plan is not pointless but crazy. If the Fed is forced to write down to zero all its Treasuries, then the Fed has no assets left with which to sop up the excess liquidity sitting in banks’ reserve accounts at the Fed as a result of QE1 & QE2. It seems also fair to assume that Paul isn’t imagining that the Fed would continue paying interest on excess reserves. So the result of his proposal would actually be to complete the heinous deed that he has been warning about – the hyperinflationary conversion of 10%+ deficits straight into greenbacks. I guess he just didn’t think it through, nor did most of the people responding to him.
But Paul is right and you’re wrong on the point of whether QE has created inflation. You’re missing two big facts. One is that although most of QE is turning into excess reserves, some of it is turning into expanding currency and broad money supply, at an inflationary pace (much higher than real growth). Second, the English word “inflation” describes many kinds of price inflation, including of asset prices and of prices in emerging markets, and not only the official US CPI index.
The Dirty Fed makes strange bedfellows. Right-wing libertarian Karl Denninger denounced Paul’s proposal, and leftist bankster-hater Yves Smith applauded it.
I think I agree with Paul: if the Dirty Fed is going to attempt a stealth monetization of the debt without Congressional authorization, we might as well call them on it and drag it into the open.
And let’s hope this whole economic debacle the Fed has created puts an end to the Federal Reserve once and for all.
I’m with Steve Forbes — let’s have some sound money again!
Thought provoking idea. Good summary. Intelligent comments.
If congress commands the treasury to do this to the Fed today, how will that effect open market operations going forward? If you tell me you are only going to run out of my restaurant without paying this one time … after consuming the biggest, most expensive meal you’ve ever ordered … even if you’ve been a good customer for years … sorry, next time you pay up front or you eat elsewhere. Don’t darken my door.
“the Fed does not intend to allow the $1.6 trillion to remain forever as zero-interest reserves or turn into currency.”
The Fed can prevent it from turning into currency by raising the interest rate it pays on reserves. The effect on both macroeconomic conditions and government finances would be roughly the same as liquidating bonds (or allowing them to mature without rolling over), so it doesn’t really matter whether the bonds are destroyed or not: it just means the Fed has to use different techniques to control the money supply. All in all, Ron Paul’s proposal is little more than an accounting gimmick.
Another point is that doing this might not accomplish the goal of not looking to the world like we’re not paying. (Follow the double negative.) Imagine you’re an investor, particularly a sovereign investor. Put aside current issue of safety, if the US decides it won’t pay here, then wouldn’t you worry we won’t pay you either?
You can say, “Well, this is different,” but why should I as an investor believe you. You’ve just sent me a huge signal that you can decide to stop paying on your debt. That is my worry, that you won’t pay. Now you’re saying you won’t pay on this debt. Maybe tomorrow you won’t pay on the debt I own.
Want to be Greece? Isn’t this somewhat similar to the Greek scenarios of pay on some, don’t pay on others? As people are screaming irrationally about how “we’re just like Greece” when we’re not, why would they then want to make us look more like Greece? I thought the goal was the opposite of that.
If I don’t trust you’ll pay, I want more interest to cover the risk. That’s part of the Greek lesson, isn’t it? So how exactly is not paying on part of our debt good for interest rates in the US? We hear all the time about “confidence” – in markets, in investment. The Chicago economists are trotting out arguments that border on the silly about how it’s not a failure of demand but of confidence. So now we take a whack at reducing confidence in the one thing we have going for us? That’s freaking insane.
Torgeir Hoeien and Andy Harless: If the Fed takes a $1.6 trillion capital loss and also loses its primary source of income, how do you expect it to make interest payments on reserves? Only by printing even more money in the future. The Fed’s assets are essential to all that it does.
…that has nothing to do with the commitment on future taxpayers to pay the bill for the previous decisions of the U.S. Congress and President.
That commitment was made when the Treasury first issued the securities, and that commitment did not change when the Fed bought those same securities.
Dean Baker has said many times over that the United States not honoring (by actually “paying off”) the T-bonds that it holds thru the Social Security trust fund would be a calamatous default that would destroy the national credit rating.
Now he says that for the United States to “destroy” the T-bonds that it holds through the Fed is “a remarkably creative” and “very reasonable” idea.
No hobgoblin of little minds for him.
What many people seem to be missing about this proposal (and I’m fairly neutral on it) is that it lays bare the absolute fact that the federal government does not need to tax or borrow in order to spend.
The practical downside to the proposal is, as others have noted, that it removes assets the Fed would ordinarily sell when it comes time to reverse course and tighten monetary policy. However, let’s not forget that at the height of the crisis, there was serious talk about the Fed not having a big enough balance sheet and that one proposal was for the Fed to issue its own bonds. There’s no reason why in theory (it would likely require legislation) they couldn’t do the same here – issue Fed bonds, sell them to the public, mop up the liquidity, buy them back the next time the economy crashes and there’s a need to loosen, etc.
But again, this discussion gets off track.
There are a lot of political implications to the fact that sovereign borrowing is really unnecessary and no one seems to want to go there.
One point to remember is that they FED already owns assets that are not worth what they paid for them. That means that a lot of the liquidity they pumped into the economy will stay their even if they sold everything they owned at market prices.
So when Mankiw leads off by stating “I think the idea is crazy, but at least it is crazy in an interesting way.” how does that indicate that he “seem(s) to think it’s not a totally crazy idea”.
jonathan,
We already are Greece. We’re running serial deficits of 10% with absolutely no possible way to pay the debt off in non-devalued dollars.
Default is a given. We’re just squabbling about the form. The least bad form is devaluation, and Ron Paul’s proposal is a step in that direction. After the devaluation, we may be able to return to sound money and fiscal responsibility.
Ricardo,
Exactly. And not just the Maiden Lane junk. If the Fed tried to unwind its bloated balance sheet of Treasuries, it would drive rates higher and find itself selling at a loss.
I tend to agree with W.C.Varones, but with one significant caveat.
Devaluation without reform does not really fix the problem.
The global currency regime is a quiet war of subsidy and manipulation, and the leveling of national sovereignty through ‘competitive’ manipulation.
The world falls to the lowest common denominator. If one large nation is an oligarchy, then all must be so to remain ‘competitive.’ This is only possible with the toleration of currency manipulation.
Devaluation kicks the can down the road. The fallacy of naturally efficient and rational markets continue to wreak havoc with public policy.
What would be the real world impact if the Fed were simply directed to forgive all of the US debt it holds?
Clearly there would be a huge accounting loss in the current year, but in the case of the Fed would that matter at all?
JDH: “Only by printing even more money in the future.”
Yes, but this money is irrelevant if it continues to remain as excess reserves. The Fed can run a larger and larger deficit on its balance sheet by repeatedly crediting interest payments to the banks that are holding reserves. Technically, it will be going deeper and deeper into insolvency, but this doesn’t matter, since it always has both the option of printing more money and the option of raising the interest rate it pays on reserves so as to forestall the need to release more money as cash. If James Bond had a license to kill, the Fed has a license to operate a Ponzi scheme.
Now at some point the Fed might have to set the interest rate very high to avoid outflows of cash, and this would affect other interest rates. In order to pay those interest rates without defaulting, the government would have to start running a surplus, which would weaken demand and tend to offset inflationary pressures. As long as there is no limit on how technically insolvent it is allowed to be, a central bank that is determined to avoid inflation, no matter how little assets it has, can always toss the ball back into the court of the fiscal authority.
Of course this situation might ultimately result in the government defaulting, despite the fact that it had repudiated its earlier debt. This just goes to my point that the repudiation of the earlier debt has no real impact.
The level of idiocy in some of these comments is astounding. Effectively defaulting on $1.6 trillion will have real and negative economic impacts. To argue otherwise is just … stupid.
@MarkOhio Pray tell, we are all ears.
The central bank has levied a printing tax on the American people (confiscated goods), and loaned those goods back to the citizens they were taken from. In this case, to the public sector. Corporations trimmed costs in response to the recession, which would have resulted in lower prices at the store in the absence of electronic printing. That is, 2% deflation rather than the 2% inflation extant. Lower prices would have allowed consumers to purchase all of the goods they made without a net increase in debt.
If the central bank had printed a trillion or so in cash, and sent all consumers an envelope filled with cash, prices would have gone up the same 2% as they did with no net increase in debt.
The central bank has customarily removed cash from circulation when inflation went beyond 3% or so. They did this by trading the bonds on their books for cash.
One problem with defaulting on the bonds is that the bank will not be able to remove electronic cash from circulation when inflation inevitably picks up. Helplessness in the face of rising inflation historically creates a loss of confidence in currency, which tends to spiral out of control. Once people lose confidence in currency, they try to get rid of it as fast as they can. Velocity increases exponentially. Markets tend to become dysfunctional at this point, as business can no longer trust price signals to determine the true state of supply/demand.
QE was a bad idea for a number of reasons, and should not be continued. However, removing the future bank’s ability to undo QE is also a bad idea.
Actually, it would not be inflationary if the banks were forced to increase their reserves to offset the destruction of the bonds.
But this debate is all nonsense. Fiat money is doomed because the incentive in a social democratic system is always towards more and more liquidity. In the end there is no way for taxation to support all of the obligations so there must be a currency revaluation or an outright default. In both cases the savers get burned, which is what they deserve for trusting the government.
I give Mankiw’s answer an F (-). Just another high level academic who doesn’t know his right shoe from his left.
I’m with MarkOhio. The fact that we are even having discussions of this sort would have horrified anyone in the country just 5 or 10 years ago. Go back 20 or 30 years, and the populace would have relegated those responsible for creating the situation to deep everlasting public shame! How is it that those who blindly created the mess through terrible policies are still in charge? Perhaps that same blindness is a large part of the reason why they can’t see how to fix it?
There WILL be vast unintended consequences, if we don’t point the ship of state back in a sustainable direction.
If the duly selected “leaders” of this country cannot put their heads together and chart a sustainable fiscal course, the $1.6T at the Fed is irrelevant. Given the 3-year leadup to the current situation, including the longstanding Icelandic, Irish, Portuguese, Spanish and Greek dramas, the claim that we somehow need more time to put our heads together is rubbish.
Fix the budget now, and we don’t need to risk the consequences of defaulting on the Fed’s asset base.
After 3 years of horrific policy response to an economic crisis resulting from terrible policy, Lady Justice is in tears, and the social contract is deeply in question. Breaking the Full Faith and Credit of the U.S. Government in ANY fashion, aside from being unconstitutional, will fracture what little remains of that social contract.
The state governments have shown that it’s possible to bring spending in line with revenue, by actually sitting down and prioritizing both spending and revenue options, and making tough choices. There has been pain but the world has not ended. If 50 states can do this individually, so can the national government!
The time has come for the Federal Government to take its medicine as well. We are long overdue to slaughter the sacred cows of both parties.
And you know, I don’t think the world would end if overall total tax rates gradually reverted to historically normal levels, provided the deficit was eliminated.
A curious proposal of argentinian style finance, apologies to A.
The fed is now showing large spread rate gains and “profits” now on its big balance sheet, kind of like the banks. But not recognising any of the writedowns needed.
This would set the Fed up for Rons big plan to eventually wipe them out.
JDH: “But of course the issue is that the Fed does not intend to allow the $1.6 trillion to remain forever as zero-interest reserves or turn into currency. If they did, that would mean more than doubling the currency in circulation and would certainly be highly inflationary. We haven’t seen inflation from the Fed’s reserve creation because most people understand that the Fed is never going to allow those reserves to become currency in circulation.”
The lack of inflation has nothing to do with “most people’s understanding of the Fed.” The lack of inflation has to do with the poor fundamentals of the economy. I think economists way overestimate their belief that the behavior of economic actors is based on nebulous intangibles like a estimates of future inflation due to future actions of the Federal Reserve. Most wage earners and businessmen haven’t a clue about the actions of the Federal Reserve. They react to tangible factors in the economy, not beliefs about the Federal Reserve.
It might be more accurate to say that some economists believe that the reserves will not cause inflation in the future because they believe the reserves will be withdrawn. But economists’ beliefs about the future is not the reason for current low inflation.
Democrats lodge all kinds of charges against Republicans saying they are not flexible on the debt ceiling issue. Guess who is talking about a filibuster?
JDH
No, the Fed’s Treasuries portfolio is probably not its primary source of income. On July 6 the Fed had $1.6 trillion invested in Treasuries and $1.3 trillion in other assets. But low-yielding Treasuries likely generate less income than other assets. Last year the central bank earned $26 billion on Treasuries and $57 billion on its other assets. Admittedly, the ratio of Treasuries to other assets is higher now than during last year, but unlikely high enough to make Treasury coupons top income category.
Yes, with interest on reserves, a tightening of monetary policy increases the Fed’s interest expenses. Currently Fed’s liabilities consist of $1 trillion non-interest-bearing notes and $1.7 trillion interest-bearing deposits. It’s possible that for some time the Fed’s expenses could exceed its non-Treasuries income. Thus, after a Paul-default, the Fed could possibly, depending on how much it tightened, make operating losses.
Over time, though, the Fed should be able to recapitalize itself as the ratio of notes to deposits rise. Therefore, although a Paul-default would imply equitable insolvency, potentially deepened by operating losses, it would most likely not wipe out the Fed’s net worth. The present value of the central bank’s future ability to acquire interest-bearing assets financed by non-interest-bearing liabilities would most likely be higher than its equitable insolvency, even given a two percent annual inflation constraint.
But if the warranted policy rate suddenly turned out to be high for a long period, it’s possible that the Fed’s net worth could become negative after a Paul-default. Then transfers from the Treasury to the Fed would be required. Of course, even if the Fed’s net worth remained positive, and it could recapitalize itself through retained earnings, Treasury revenues would fall during recapitalization.
However, the important question is whether a Paul-default would increase the risk of too high inflation, as Mr. Hamilton seems to argue. I think the answer is no.
There are two conditions for inflation control: an appropriate policy interest rate and sufficient future real primary public surpluses to back the real value of the public debt at the price level produced by the warranted policy rate. Paul-default does not make these tasks harder (or easier). The public debt consists of federal debt and Fed debt, and a Paul-default increases the Fed’s net debt in tandem with the cut in the federal debt. The relevant public surpluses are the consolidated federal and Fed surpluses, so transfers between the Treasury and the Fed are ineffectual. Also, whether future primary surpluses are used to recapitalize the Fed or to reduce the federal debt is irrelevant.
A Paul-default would be an accounting gimmick, reflecting the loophole that exempts Fed liabilities from the debt ceiling. It wouldn’t have any implication for monetary or fiscal policy.
(1) “it is like a tax on bank financing”
Paying for what the banks already own is the tax. Eliminating REG Q CEILINGs was the tax. The source of time/savings deposits to the CB system is demand deposits, directly or indirectly via the currency route, or the banks undivided profits accounts.
Also, contrary to Milton Friedman, legal reserves are not a tax under the economics of fractional raserve banking. But the payment of interest on excess reserves is contractionary & induces dis-intermediation within the non-banks.
(2) “policy will therefore impede the financial system’s ability to intermediate between savers and investors”
Never are the commercial banks intermediaries in the lending & investing process. From a systems viewpoint, commercial banks (DFIs), as contrasted to financial intermediaries (non-banks): never loan out, and can’t loan out, existing deposits (saved or otherwise) including existing transaction deposits (TRs), or time deposits (TDs) or the owner’s equity, or any liability item.
When CBs grant loans to, or purchase securities from, the non-bank public, they acquire title to earning assets by initially, the creation of an equal volume of new money- (transaction deposits -TRs) — somewhere in the banking system. I.e., commercial bank deposits are the result of lending, not the other way around.
The lie that QE isn’t being converted into currency is repeated so often that many people believe that it’s true. In fact currency in circulation has grown by 23% since end-August 2008. That’s an obviously inflationary pace.
As for broad money, the more liquid types – checking, savings and other accounts that can be withdrawn instantly without penalty – have been growing very quickly, while time deposits and money funds have shrunk. Here QE is counteracting deleveraging and exacerbating liquidity preference. A lot of economists are being much too blithe by looking only at the M2 total number without looking at its internal dynamics.
And as I’ve pointed out many times here, excess reserves are not sterile. To sterilize money, a central bank must borrow money from banks for some term. Excess reserves are in fact the most liquid form of money which with banks can do whatever they want whenever they want. Many economists mistakenly believe that the only important transactions that can be made with excess reserves are when banks buy from / lend to non-banks, as those transactions deplete the total volume excess reserves and increase currency and broad money. But there are also a huge amount of transactions on a daily basis between banks in which excess reserves merely pass from one bank to another without changing the total or creating any currency or broad money. For example if banks are bidding up the price of a particular asset type that is held largely by banks, such as agencies, relatively little of the money spent doing so decreases excess reserves.
(1) “excess reserves are not sterile”
They are idle and unused. IOeR’s expansion paralleled POMO purchases without drawdown.
(2) “excess reserves merely pass from one bank to another without changing the total or creating any currency or broad money”
One piece of evidence comes from the frbATL is that: “Reserve velocity“ declined: from its peak in December 2007 of 353, to 2.4 as of December 2010. Reserve velocity is defined as the ratio of the average daily value of transactions on FEDWIRE, divided by the daily average value of IBDDs (reserves held at the Federal Reserve.
Another piece of evidence comes from the distribution of reserves: “where 85 percent of the increase, or about $670 billion, ended up on the balance sheets of foreign-ON THE BALANCE SHEETS OF FOREIGN-RELATED INSTITUTIONS in the United States.
No, your too blithe looking at only excess reserves without looking at the sum total of reserve dynamics.