Ron Paul Proposed A Fed Masterstroke That Can End The Debt Ceiling Crisis At Once!

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by: Shareholders Unite

While the fight on the debt ceiling continues with the White House unwilling to give in to what they see as extortion (which could set a bad precedent for future negotiations) and the Republicans unwilling to walk away with this without at least some concessions, is there any way out of this?

Well, apart from an epic back-down on either side, there actually is, and it's something we've suggested earlier (albeit not within the context of these debt ceiling negotiations). Central banks can simply cancel part of the debt. Up until the part it has accumulated as a result of QE1, 2 & 3, or roughly $2 trillion.

That sounds like a very easy way out, and indeed it is. With a stroke of a pen, there would be roughly $2 trillion less public debt outstanding, so the debt ceiling would be out of reach for years.

But isn't this debt monetization, stuff that would trigger hyperinflation like it did in the Weimar Republic and Zimbabwe? Well, yes, but here's the thing. The monetization already happened, the Fed already bought those government bonds in exchange for money, and inflation hasn't taken off (in fact, despite many dire predictions, it is still very subdued, and that's no accident, see below).

You might think that the political right will be up in arms against this debt monetization -- we have a surprise for you. Iconic figure of the right (at least until recently) Milton Friedman blamed excessively tight monetary policy for the 1930s depression (and Bernanke famously promised him on his 90th birthday celebration not to repeat those mistakes).

Friedman also suggested Japan to embark on QE at the end of his life, and he was even willing to contemplate more drastic measures, like the proverbial money thrown from helicopters.

What's more, to our considerable surprise, this policy has been proposed by no less than Rand Paul, who seems to dislike almost anything the Fed does as long ago as 2011:

Rep. Ron Paul on Monday introduced legislation that would lower the federal government's debt by canceling the roughly $1.6 trillion in debt held by the Federal Reserve. Paul has argued for the last few weeks that the idea represents a quick way to make the growing fiscal crisis more manageable. Under his bill, H.R. 2768, the $1.6 trillion that the Treasury owes to the Federal Reserve would disappear.


Is there a downside? Well, in essence, this is money that the government owes to itself, so it's basically an accounting exercise. The money for it has already been "printed" and to understand why this hasn't done any harm (like setting off inflation), you have to understand what kind of economic crisis we're in.

In a balance sheet recession, households (and banks) overriding aim is to repair their balance sheets (deleveraging), broken by the implosion of the housing bubble which wiped off $9 trillion of household balance sheets. In order to do that, households started to save more and spend less, and banks lend out less, all of which greatly reinforced the economic crisis.

It's also crucial to understand that it is exactly this private sector deleveraging that makes normal monetary policy ineffective. Even at zero interest rates, households were not induced to embark on borrowing and spending, and banks not induced to lend out. Hence QE, but all that does is stuff the banking system with reserves, which don't get lend out and just sit there, on bank balances as excess reserves.

As long as credit demand doesn't recover fully and the economy anywhere near full capacity, there is virtually no risk of inflation taking off, nor of any bond market crisis as a balance sheet recession is one that generates its own savings, the result of deleveraging.

The Friedmanian idea of helicopter money is actually much better than QE, as it directly injects money into the veins of the economy, bypassing the banking system which isn't effective because banks and households are deleveraging, repairing their balance sheets.

It would simply be monetary policy by other means, as interest rates can't be lowered, and QE isn't very effective (if at all).

Canceling part of the government debt would amount to the same as helicopter money, although the stimulating effect of the government expenditures already took place, it merely cancels the debt that was issued to finance these.

Another objection one could have is that this creates a dangerous soft budget constraint for the government. If they could spend without any negative consequences (increasing taxes or debt), they could easily spend more. The answer to this is twofold. This is, in fact, exactly what is necessary under the present economic conditions (that is, private sector deleveraging).

When the private sector spends less and saves more in order to repair balance sheets, something must compensate for that to prevent a dangerous Fisherian debt-deflationary spiral.

A second thing to realize is that this trick only works under the present economic conditions (we can't stress that enough). When the private sector (and financial institutions) deleveraging has come to an end and the economy approaches full employment and full capacity, normal economics resumes, a difference we tried to explain here.

So under normal economic conditions, a stunt like this wouldn't be effective, and it would have a lot of negative consequences (it would indeed trigger inflation and higher yields), so the temptation would be very low (even if, like in Zimbabwe, policy makers tried and found out for themselves).

So there wouldn't be much of a moral hazard problem by softening up the public sector budget constraint. It would work exactly under those circumstances where it is useful, and be counterproductive under normal circumstances.

It would mess up the Fed's balance sheet, but if that's the price for either restarting the economy (helicopter money), or at least avoiding debt ceiling mayhem, that seems a price well worth paying, as it's quite difficult for central banks to go bankrupt (see the excellent paper of Willem Buiter on this subject).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.