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.