Congressman Ron Paul (R-TX) is apparently proposing that the U.S. Treasury simply refuse to pay interest and principal on the $1.6 trillion in Treasury securities currently owned by the Federal Reserve. Dean Baker, Greg Mankiw, Steve Williamson, and Stephen Gandel all seem to think it’s not a totally crazy idea. Here’s what I think they’re missing.
Steve Williamson frames the question as follows:
Now, to work through this, consider two alternative scenarios. First, suppose that, in the absence of Paul-default, the Fed holds the Treasury debt it has acquired until maturity. In this case, clearly Paul-default cannot make any difference. Without Paul-default, the Treasury makes the payments on the Fed’s Treasury holdings to the Fed, and the Fed sends those payments back to the Treasury. With Paul-default, the net flow between the Fed and the Treasury is the same: zero.
Here we need to distinguish between the Fed’s income statement, which keeps track of its profit or loss, and the Fed’s balance sheet, which keeps track of its assets. It is true that the Fed routinely turns over its income to the Treasury. It is not true that the Fed routinely turns over its assets to the Treasury.
Holding an asset to maturity does not generate an income flow equal to the asset’s par value. Maturation just means that the asset is replaced with another (cash) of equivalent value, a transformation that generates no income. What would actually happen under Williamson’s first scenario, if the Treasury were to retire the debt held by the Fed when the bonds reach maturity, is that the Treasury would have to debit its account with the Fed by the amount of the maturing principal. The funds in that account in turn would have been collected from taxpayers– when they wrote checks to the IRS, those checks were cleared by debiting the Federal Reserve deposits held by the taxpayers’ banks and crediting the Treasury’s account with the Federal Reserve. The net result, if the Fed were to hold the securities to maturity, would be that tax receipts would be used to retire the reserves that the Fed initially created when it originally bought the Treasury debt. In the normal course of affairs, if the Fed holds Treasury securities to maturity, upon maturity total reserves would contract.
What Williamson has in mind with his first scenario is not the Fed simply holding the debt to maturity, but instead the Fed rolling over its holdings of Treasury securities in perpetuity. In this case, his analysis would be correct. Each month the Treasury makes a payment to the Fed (which counts as the Fed’s income), and each month the Fed returns that income to the Treasury (which counts as an offsetting Treasury receipt). This transaction is a complete accounting wash, and it would be entirely equivalent if both the Fed and the Treasury simply agreed to cancel the obligation. The correct conclusion is that, if the Fed intends to allow the $1.6 trillion currently held as Federal Reserve deposits by private banks to remain as currency or reserves on which it pays no interest forever, then there would be no need for the Treasury to think of the Treasury securities held by the Fed as something for which it ever needs to raise taxes to repay.
But of course the issue is that the Fed does not intend to allow the $1.6 trillion to remain forever as zero-interest reserves or turn into currency. If they did, that would mean more than doubling the currency in circulation and would certainly be highly inflationary. We haven’t seen inflation from the Fed’s reserve creation because most people understand that the Fed is never going to allow those reserves to become currency in circulation. Congressman Paul has been asserting that the Fed’s actions already have produced inflation, a claim for which I see no evidence. But the congressman’s latest proposal would help improve the quality of his forecast considerably.
Congressman Paul’s position seems to be that he never approved of the Fed’s purchases of U.S. Treasuries, so why should taxpayers have to sacrifice to pay back the Fed? The key point to remember here is that it was the Treasury, not the Fed, that initially decided to borrow these sums. Any time Congress spends more than it takes in as taxes, it is imposing a commitment on future taxpayers to make up the difference. The taxpayers owe that money whether the Fed buys the securities or not. The Fed made a determination that by temporarily holding a greater portion of that Treasury debt than usual, it could alleviate some of the suffering and waste that results from unemployment and idle production capacity. Reasonable people can and do disagree about the extent to which the Fed’s measures were helpful for that purpose. But that has nothing to do with the commitment on future taxpayers to pay the bill for the previous decisions of the U.S. Congress and President. That commitment was made when the Treasury first issued the securities, and that commitment did not change when the Fed bought those same securities.
Now, in fairness, Dean Baker is not endorsing the proposal of a starkly inflationary outright default, but instead proposes preventing the reserves from becoming currency in circulation by simply requiring banks to hold onto the reserves. I give this part of Greg Mankiw’s answer to his exam question a grade of A+:
Assuming the Fed does not pay market interest rates on those newly required reserves, it is like a tax on bank financing. The initial impact is on those small businesses that rely on banks to raise funds for investment. The policy will therefore impede the financial system’s ability to intermediate between savers and investors. As a result, the economy’s capital stock will be allocated less efficiently. In the long run, there will be lower growth in productivity and real wages.