A Bipartisan Debt Ceiling Fix

Representative Alan Grayson from Reuters

Warren Buffett calls the debt ceiling a “nuclear weapon, too horrible to use.” Obama administration official Jason Furman says the consequence of a default on U.S. government debt is “too terrible to think about.” When asked about a default, Wells Fargo strategist James Kochan simply commented, “Holy cripes.”

With this crisis, America is risking financial Armageddon. The default of Lehman Brothers on its $613 billion of debt ignited a chain reaction in the financial system, nearly destroying the U.S. economy. A default by the U.S. government on $17 trillion of debt — debt that has been considered the safest in the world — could be far worse. 

But at heart, this is not a debt problem. It is an accounting problem. The Treasury Department issues U.S. debt, and lots of it. So you would think that America is deeply indebted to its bondholders. Yet increasingly, it is the U.S. monetary authority, the Federal Reserve, and not private investors, who buys this debt.

So a simple solution to the impasse is as follows: Federal Reserve Chairman Ben Bernanke should simply cancel the Treasury debt that it owns. The government can just forgive the government’s debt.

This wouldn’t solve the debt problem entirely. The Federal Reserve doesn’t own all U.S. government debt; it owns only roughly $2 trillion of it. (Well $2,076,927,000,000.00, as of last Wednesday, but who’s counting?)

Yet canceling this debt would give the government substantial room under the debt ceiling to manage its finances. It would end the debt ceiling standoff in Congress, and it would prevent a default.

The debt held on the balance sheet of the Federal Reserve can be canceled without any significant consequence, because it is a bookkeeping artifact corresponding to the money supply. In essence, the government owes this money to itself. If I owe money to myself, I can cancel that debt at will and without consequence, essentially taking it out of my left pocket and putting it in my right pocket.

Last year, the Federal Reserve declared a “profit” of roughly $91 billion, much of which came from interest payments from the U.S. Treasury. The Federal Reserve then quickly remitted nearly all of this profit right back to the U.S. Treasury.

The Federal Reserve does this every year. Reducing or eliminating this unearned “profit” actually will provide a more realistic view of federal finances.

I am a Democrat, and known as a progressive. But this idea was put forward a few years ago not by me, or by a member of my party, but by Republican Representative Ron Paul.

He thinks, as do I, that the Federal Reserve’s dramatic expansion of its balance sheet is simply a way of financing the government by printing money. The Fed isn’t really “buying” Treasury bonds, it is just letting the government finance its deficit by adding to the money supply.

If this plan were enacted, there conceivably might be some operational problems for the Fed, but nothing compared to the nightmare of a default on Federal debt. Some of the Fed’s Treasury debt facilitates Fed open market operations, which is part of how the central bank manages the money supply. Surely it would be much easier for the Fed to change its money supply management techniques, though, than to figure out how to manage open market operations using defaulted Treasury bonds.

While canceling the Treasury debt held on the Federal Reserve balance sheet might be considered unorthodox, it is no more unorthodox than the quantitative easing that has added much of this debt to the Fed’s balance sheet. In any event, preventing a financial meltdown, with its attendant risks of interest rate and price spikes as well as staggering employment losses, is certainly central to the Federal Reserve’s mandate of ensuring price stability, maximum employment and moderate, long-term interest rates.

Bernanke could alleviate the debt ceiling crisis simply by canceling the debt held on the Fed’s balance sheet. I’ve written to him, and asked him to do so.

Let’s hope that he does.

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(COMMENTARY)

This may sound like a fringe idea. But the Financial Times noted in an article last year entitled “Will central banks cancel government debt?”:

It is obvious that governments are struggling to find the correct balance between controlling public debt … and boosting the rate of economic growth. The former objective requires more budgetary tightening, while the latter requires the opposite. Is there any way around this? One radical option now being discussed is to cancel (or, in polite language, “restructure”) part of the government debt that has been acquired by the central banks as a consequence of quantitative easing (QE). After all, the government and the central bank are both firmly within the public sector, so a consolidated public sector balance sheet would net this debt out entirely.

Adair Turner, the chairman of the UK Financial Services Agency, and reportedly a candidate to become the next governor of the Bank of England, made a speech last week that said more unorthodox options, including “further integration of different aspects of policy”, might need to be considered in the UK. Two separate journalists (Robert Peston of the BBC and Simon Jenkins of The Guardian) said that Lord Turner’s “private view” is that some part of the Bank’s gilts holdings might be cancelled in order to boost the economy. Lord Turner distanced himself in public from this suggestion on Saturday. However, the notion will now be widely discussed.

Similar proposals have however been widely debated by economists in the past. This goes back at least as far as the works of Abba Lerner in the 1940s on “functional finance”and the role of fiat money. More recently, the Modern Monetary Theorists have reawakened Lerner’s ideas.