Debt Ceiling: Could Ron Paul's Plan Save Us From Disaster, twice?

Stephen Gandel
Tuesday, July 5, 2011
http://curiouscapitalist.blogs.time.com/2011/07/05/debt-ceiling-could-ron-pauls-plan-save-us-from-disaster-twice

Is Congressman Ron Paul our savior?

The Republican, and libertarian, who is running for President, again, in the past few days has been floating a plan that has the potential to end the debt ceiling standoff, for now, and eliminate the growing possibility that the U.S. government could have to default on its debt, which could cause disastrous economic consequences. Even better, in Ron Paul's plan Republicans and Democrats wouldn't have to come to some compromise about taxes or spending cuts. In fact, they wouldn't even have to vote to raise the debt ceiling, at least not for a year, perhaps more. And that's not all. Paul's plan would not only solve the debt ceiling problem, it also might eliminate any harmful after shocks the Federal Reserve's QE2 program could have on the economy.

Not possible, you say. Well at least one left-leaning economist, Dean Baker, thinks the plan has promise. Here's why:

Paul's plan starts with the Federal Reserve. In the last year or two the Fed has been buying up U.S. Treasury bonds in an effort to lower interest rates and boost the economy. The most recent round of that buying has been dubbed QE2, and has come under a good deal of criticism, though most economists agree that it was a generally helpful policy. The result is that the Fed now holds nearly $1.7 trillion in U.S. debt. But that is really phony debt. The Treasury pays the interest on the debt on behalf of the U.S. government to the Fed, which in turn returns 90% of the payments it gets back to the Treasury. Nonetheless, that $1.7 trillion in U.S. bonds that the Fed owns, despite the shell game of payments, is still counted in the debt ceiling number, which caps that amount of total Federal debt at $14.3 trillion.

Paul's plan: Get the Fed and the Treasury to rip up that debt. It's fake debt anyway. And the Fed is legally allowed to return the debt to the Treasury to be destroyed. A trillion and a half dollars is currently about what spending is expected to exceed tax revenue in 2011. And the deficit is expected to dramatically shrink in 2013 and beyond. So cut the debt by $1.7 trillion and you could run the government as is for at least the next year, and perhaps into 2013. By pushing the debate past the presidential election cycle you might be able to get some of the politics out of coming to a smart solution. What's more, under the current scenario, the Federal Reserve would eventually have to sell that debt back into the market. That could cause interest rates to rise. Rip up the debt and you don't have to worry about what the added selling pressure of the Fed would do to the market.

There are of course a number of catches. First of all, the Fed probably couldn't sell off all of its Treasury holdings. Some of the interest, say 10%, it gets from those bonds it holds onto the Fed uses to fund its operations. The Consumer Financial Protection Bureau, for instance, by way of Dodd-Frank, specifically gets funded from the interest that the Fed collects on the U.S. Treasury debt it owns. Second, even in good times, the Fed always holds a significant amount of Treasuries, if not as much as it has now. The Fed had about $700 billion in late 2007, just before the financial crisis began to unfold. Take that as a baseline, the Fed would only be able to retire about $1 trillion in U.S. debt. That would probably put us in the same debt debate situation we are in now sometime next summer or early fall, which is the heart of presidential election season, potentially making the debate even more politically charged than it is now. Lastly, that government debt that the Fed owns is back by bank reserves. They are technically excess reserves. But eliminate the debt and those reserves go away, too, which could lead to less lending by the banks.

But the biggest potential draw back is this: It just looks bad. It looks like we don't live up to our obligations. Of course, government finances, especially those of an economy as big as ours are hard to grasp. As much as Sarah Palin and the rest of the Tea Party would like to think, the government doesn't have to balance its checkbook in the way that individuals have to. But nonetheless, if the government regularly used the Fed to create money to buy up its debt rather than paying it off, it seems wrong. The optics are bad. "It smacks of the third world," says Allan Meltzer, a Fed historian. "It's what Zimbabwe would do."

Drawbacks aside, if the Democrats and the Republicans can't get to a compromise by July 22nd, I think the Fed option is a viable one. It's definitely better than defaulting. And it is probably better than massive cutbacks in government spending that could potentially send us right back into a recession anyway. The optics of a government unable to come to a compromise are bad already.

Stephen Gandel is a senior writer at TIME. Find him on Twitter at @stephengandel.