Saturday, January 19, 2013

John Cochrane On the Debt Ceiling

John Cochrane is a big name academic, who works on the borderline between finance and macroeconomics. Here are some of this thoughts on current debates over the debt ceiling. He makes 4 major points:

I. Why the limit binds

Why can't the government just pay its bills by printing money, i.e. creating reserves? Sure, you might worry about inflation sooner or later, but this is a legal question. The government can print money to pay its bills, no?

Well, no, which is really interesting.

For the Fed to "print money," meaning to create reserves, it has to buy some other asset. Though the Fed can manufacture money costlessly, it legally can only do so by buying assets. The Fed cannot engage in fiscal policy, and printing up checks and sending them to taxpayers -- or even dropping cash from helicopters -- is fiscal, not monetary policy.

And the debt limit applies to all Federal debt outstanding, including debt held by the Fed. So, as long as the Fed buys only Treasury bills, the debt limit does, in fact, stop the government as a whole from "printing money" (creating reserves) to pay bills. …

Well, the Treasury has the actual printing presses that make good old fashioned cash. Why can't the Treasury  just print up money and use it to pay bills? (Or, deposit the cash at the Fed, thereby get reserves, and transfer the reserves by writing checks.) No, that's illegal too. The Treasury prints the bills, but they can only be issued by the Fed, and in return for already-created reserves.

So the architects of our monetary system and debt limit weren't so dumb after all. …

II. Clever solutions

So, our army of clever lawyers and policy wonks is hard at work finding loopholes, either ways to create "debt" that doesn't count as debt, or ways to print money to pay bills anyway.

Here's where the trillion dollar coin idea came up. James Pethokoukis at the AEI covers a few more clever ideas. There are various ways that the  US government could essentially send tradeable IOUs in place of checks, as California did, avoiding its "balanced budget" rules and the prohibition on states issuing currency.  Cash is, in the end, no more or less than a tradeable IOU of the US government.

A less obvious and more realistic option strikes me as important going forward. I assumed above that the Fed only buys Treasury bills when it creates reserves out of thin air. But that's no longer true. During the financial crisis, the Fed bought commercial paper, and lent directly to various financial institutions. (It called the loan an "asset" on its balance sheet, so it seems like the Fed is buying something of value.) Now it is buying and holding mortgage-backed securities.

This is fiscal policy. When the Fed lends directly or buys assets other than Treasuries, the total debt + money increases. The traditional restriction that the Fed should only buy Treasuries separates it from fiscal policy.

III. Default

One of the silliest constantly-repeated red herrings is that running in to the debt limit will force the US to default on its debts and cause a global financial disaster. …

…If a $100 bond comes due, the Treasury can sell a new $100 bond to pay off the principal without increasing the total amount of debt.  And there's still $2.5 trillion of tax revenue coming in. That's plenty to cover interest payments. If anything, the law is pretty clear that interest payments on the debt are the last thing the government can stop paying, not the first.

This is simply a red herring. Social security checks might stop, farm price support payments might stop, they might have to send the TSA home from airports and let the NRA take care of security (joke here, please don't go nuts). All this might cause a lot of hardship, but there is nothing forcing the government to default. Default would be a choice.
Update: In an official statement, the White House chimes in

“There are only two options to deal with the debt limit: Congress can pay its bills or it can fail to act and put the nation into default. When Congressional Republicans played politics with this issue last time, putting us at the edge of default, it was a blow to our economic recovery, causing our nation’s credit rating to be downgraded. The President and the American people won’t tolerate Congressional Republicans holding the American economy hostage again simply so they can force disastrous cuts to Medicare and other programs the middle class depend on while protecting the wealthy. Congress needs to do its job.”

My [Cochrane’s] emphasis.

Now it's not so clear. … our government might in fact be tempted to default. Not in a big way, but in the usual muddle that governments do. …

These are far-off low-probability scenarios. Still, the possibility of explicit default -- not now, not next year, but once things get really bad -- is not as remote as I had thought.

Which, by the way, is not necessarily a bad thing. [Tufte’s emphasis] Governments who really cannot monetize their debts but must repay them or face the horrible costs of default tend to figure out how to balance their budgets, and they get better interest rates.

IV A better ceiling? 

These occasional battles over the debt ceiling are pretty obviously not an ideal way to run fiscal policy. But they do have an important function in the political battle to limit spending.
Such devices are important. …

… Budget numbers are so full of accounting tricks and gimmicks, that even passing a budget can fail to have the strong force limiting spending that one would hope. It was budget rules that gave us "temporary" Bush tax rate changes in the first place.  

By contrast, the actual amount that the government has to go out and borrow is a hard number, and it seems to pose a stronger constraint than the budget act. That makes it a blunt instrument, but a more useful instrument than the fine instrument that seems not to work.
But occasional crises are obviously not a good way to impose a bit of discipline. So, herewith a modest proposal in two parts:

First, fix the remaining loopholes. No platinum coins.  Federal "debt" should include Federal Reserve liabilities (cash and reserves) net of Treasury debt held by the Fed. Harvest the creative work of the blogosphere from the past few months, and reinforce the ceiling.

Second, in place of a single ceiling, that is then periodically raised by a few trillion after a big fight, put in a ceiling path. If $1 trillion deficits ($80 billion per month) seem like a lot, renew the debt ceiling at $50 billion per month this year …

Read the whole thing. Cochrane blogs at The Grumpy Economist.

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