Ron Paul's Surprisingly Lucid Solution to the Debt Ceiling Impasse By Dean Baker | July
2, 2011 | 12:00 am
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.