I remember the first time I heard Rep. Ron Paul (R-Texas) speak when I was in college. I thought to myself, this guy is brave. He's bold. He doesn't give a damn what anyone else thinks. I like that. But he's also living in his own wacky bubble of reality. Just look at his latest big idea.
The government is buried in debt (or have you heard that already?) and quickly approaching default if it can't or won't raise the national debt ceiling over the next few weeks.
Paul's solution is simple: The Federal Reserve has purchased $1.6 trillion worth of government bonds since the financial crisis began in 2008. These bonds, while owned by a government agency (the Fed), are liabilities included in the government's $14 trillion-plus total debt load. If the Fed simply ripped them up (part of Paul's broader plan of eliminating the Fed), voila …total debt would shrink by $1.6 trillion. "They're nobody," said Paul last week. "Why do we have to pay them off?"
The idea has its merits. Canceling debt owned by the Fed doesn't directly burden anyone. Interest payments the Fed receives on these bonds are remitted back to the Treasury -- this really is money the government owes itself. So why not just forget about it?
Well, there are a few big reasons.
Most seriously, if Congress instructs the Fed to destroy its bonds, that would almost certainly qualify as selective default. Rating agencies -- Moody's
Over time, a credit downgrade could cost the government more than it saves from the Fed's repudiation, thanks to higher interest rates on existing debt. Current projections see the government spending $562 billion on interest payments in 2016. You can safely double that figure if default sends interest rates lurching.
Even if rating agencies don't consider the move a default (they're known to do funny things), private Treasury investors would find little solace in the government merely defaulting on itself. They'd see it as outright default, and respond accordingly. As Carmen Reinhart and Ken Rogoff painstakingly outline in their book This Time is Different, history is packed with examples of governments repudiating debt on a select group of investors (typically foreign investors, since they don't vote). Stiffing one group invariably spooks all others, sparking a who's next? guessing game, and sapping all hope that the government can make hard choices about tax hikes and spending cuts.
Second, the Fed is a bank with assets, liabilities, and equity. If it tore up all its assets, it would be insolvent. This isn't a hard problem to fix, since it can print money and purchase assets -- typically Treasuries -- at will. But that creates a circular problem: Ripping up Treasuries would make the Fed insolvent, and regaining stability might require … purchasing Treasuries.
Third, there's good reason for the Fed to own Treasuries. Quantitative easing expanded the monetary base by trillions over the past two years. This hasn't yet ignited inflation, because almost all the money is sitting in excess reserves at the Fed. Someday, though, the cash will enter the economy, sending inflation pressures rising. This needn't be scary, since the Fed can sop up excess liquidity by selling the Treasury bonds it now holds on its balance sheet, eliminating cash printed during the financial crisis.
But that option gets really sticky if the Fed rips its Treasuries up. A decade ago, when budget surpluses promised to eliminate all government debt in due time -- ah, those were the days -- policymakers worried that the Fed wouldn't have enough Treasuries to do one vital part of its job. "Without Treasuries," wrote James Glassman in 2001, "the Fed will have a tough time conducting its 'open-market' operations, the practice of buying and selling bonds that keeps interest rates where the central bank wants them."
Shredding the Fed's Treasuries today would create the same problem. Some, including economist Dean Baker, say we can avoid this by using reserve requirements to regulate monetary policy, making banks like Citigroup
Here's a Paul-esque bold idea to work around the debt ceiling problem: Get rid of it. The ceiling has been raised 87 times since 1945, which has successfully prevented us from running up exactly zero dollars of debt. Its sole purpose, it seems, is to create something to argue about.
If spending needs to be cut, cut it. If taxes need to be raised, raise them. Putting up a self-imposed roadblock that's nearly always quickly pushed aside, and talking about repudiating national debt and overhauling monetary policy when it can't be pushed aside, accomplishes nothing and harms everything.
Fool contributor Morgan Houselowns B of A preferred. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of JPMorgan Chase. The Fool owns shares of and has opened a short position on Bank of America. Motley Fool newsletter services have recommended buying shares of Moody's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.