Two cents on the trillion dollar coin, and a debt-limit schedule

The Fed and Treasury say they're not going to try the trillion-dollar coin idea to avoid the debt limit. But the episode is very revealing about how our fiscal and monetary policies work, (or don't, as the case may be), numerous misconceptions floating around, and leads to a thought on a better way to approach the same objectives, which might be a useful compromise for both sides.

I. Why the limit binds

First, just to be clear, let me clarify the playlist: 

• Debt: US government bonds, issued by the Treasury. Promises to pay for your healthcare is not "debt," and if the government reneges on that promise it's not a "default."
• Cash: Bills and coins.
• Reserves: Essentially checking accounts at the Fed. Banks may freely obtain cash in return for reserves and vice versa.We often say "the Fed prints money" when in fact what it does is to create reserves.

In the first debt-limit debate, I was initially puzzled that it was a problem at all. The "debt limit" does not include currency or reserves, though both are functionally US government debt. That seems like an unfortunate oversight:  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. To do so, the Treasury has to issue debt, borrowing the money, pay its bills, and then get the Fed to buy the debt, so that in the end there is more money outstanding. But a debt limit stops this operation.

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. Though we have a fiat money system, and, drawing a circle around the whole government, it should be able just to print money and give it to people (social security) or buy tanks and stuff with the printed money, the debt limit does pretty well constrain the government budget.

To emphasize, this isn't about a fight between Treasury and Fed. They can agree they want to print money to evade the debt limit. But they still can't do it. It's a limit on what the  government as a whole can do.

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. Apparently, though the Treasury is not allowed to print money or regular coins and pay bills with them, it can issue "commemorative" coins and sell them directly.  So, most simply, it could in principle, pay for a trillion dollars of deficit by minting a trillion dollars worth of commemorative coins. (Coins are just metallic dollar bills; they don't have a metallic value equal to face value.)

That's not very practical. But as a little favor to the platinum lobby, there is no limit to the denomination of platinum coins the Treasury can issue. So, the idea is this: make a trillion dollar coin out of platinum. Deposit the coin at the Fed, just as the Treasury now deposits cash. The Fed creates a trillion worth of reserves in the Treasury's checking account, and the Treasury can merrily write checks.

If the Fed goes along and sells its roughly $1 trillion dollars of Treasury securities, it can soak up that new cash, putting debt in private hands. For the first trillion, the government isn't even "printing money," it is exactly as if the Treasury borrowed a trillion dollars by issuing a trillion of new debt.

(Small update: Many commenters note agency debt. Thanks. As the Fed has about a trillion dollars of Federal debt, so the other agencies have about $5 trillion dollars.  Selling the Social Security "trust fund" would work exactly the same way, and effectively borrow money without busting the debt limit. And it's a lot bigger. Tom Saving explains here. To fund payments other than Social Security, the Treasury would have to come up with some way of telling Social Security "we promise to pay you back" that didn't count as "Federal Debt." I don't know the laws that limit this action. But it's surprising that so much blogosphere creativity has gone in to spending the Fed's $1 trillion rather than the much larger pot of agency debt.)

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. As some of James' clever ideas point out, you just have to be a bit clever to channel this newly-created money to social security recipients.

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. (This goes right up there with "Greek default will force it off the Euro" in the fallacies-casually-repeated-as-facts department.) 

Just yesterday, driving in to teach my Saturday morning MBA class, Scott Simon's soothing voice on NPR introduced a trillion-dollar coin piece with the statement

... it will certainly be no laughing matter if the U. S. Congress refuses to raise the borrowing limit and the U. S. government defaults on its debt. ...

No Scott, (or NPR writers). 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.

OK, NPR can be forgiven for passing along this trope. But what's Paul Krugman doing with this obvious... I'm having a hard time finding a polite word...piece of misinformation? Writing in the actual Times, which is supposed to be fact-checked:

Finally, just consider the vileness of that G.O.P. threat. If we were to hit the debt ceiling, the U.S. government would end up defaulting on many of its obligations. This would have disastrous effects on financial markets, the economy, and our standing in the world.

Parse that carefully for Clintonian veracity. "Defaulting on its obligations" could mean not paying promised farm price supports, or delaying payments (as the State of Illinois does) to vendors, not actual default on Federal debt. So it's just a nanometer this side of factually incorrect. But you'd have to be very knowledgeable not to infer from the following sentence "disastrous effect on financial markets" that Krugman is not talking about actual "default" (a term meaning "not paying back bonds") from this more metaphorical sort of "default" (meaning breaking an implicit promise).

In his blog, he's less circumspect

By contrast, nobody really knows what happens if America defaults, even briefly. The whole structure of world financial markets is built around the use of Treasury bills as the ultimate safe asset; what happens if they lose that status? It would certainly be an interesting experiment, but one best carried out if you have plenty of bottled water and spare ammunition in your basement.

I agreed on the consequences of default. But, as much as he dislikes Republicans and the debt ceiling, passing on the canard that hitting the ceiling implies a default on Treasury debt is just a little... here we go a search for a polite word again...misleading, no matter how useful it would be to the give-in-and-spend side of the debate if those obstructionist Republicans were to believe it.

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 emphasis. The war on the English language continues. End update

However, there is some news here about the long-run chance of US default. I started this whole blog with my previous view that the US can always print its way out of fiscal trouble. While we might have inflation, a nation that borrows in its own currency should always be able avoid the costs of explicit default.

Now it's not so clear. The laws limiting spending by money-printing in the face of a debt limit are surprisingly effective.  Faced with really disastrous spending cuts - and a trillion per year is more than just farm price supports and windmill subsidies -- and not being able to print money, our government might in fact be tempted to default. Not in a big way, but in the usual muddle that governments do. It could delay interest payments for example, or force exchange of maturing debt for new longer-term debt. But Krugman's right, such shenanigans would seriously impact the stature of US debt in financial markets, which tolerate inflation but do not tolerate explicit default.

Moreover, let's think about what happens when the "debt limit" is not imposed by Congressional action, but by bond markets refusing to lend anymore. I had always thought this would mean monetization and inflation. But the chance it could mean default, truly Greek-style, is raised, at least up from zero, by these limits on monetization.

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. 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. Though we hear repeated over and over that the debt limit just finances the same spending that Congress passes, any household knows that a budget is a good idea. When one spouse wants to go get another six pack, the other one may be able to point to a budget and enforce spending priorities.

And for Congress too, a budget would be a useful and  better way to limit spending. Lay out both taxing and spending, preferably over a number of years, and then stick to it. The budget then takes on the force of an overall constraint; Congress can say to a worthy petitioner, "We would love to help, but if we give it to you we have to take it from someone else; the budget won't let us do it."

However, the law requiring Congress to pass a budget seems not to have the same force as this set of laws governing the debt ceiling. (Ironic tone). Also, 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, and $40 billion per month next year.

So, the law reads, "the debt ceiling shall be $16,050 billion on March 1 2013, $16,100 on April 1 2013, $16,150 on May 1 2013..."  (I'm obviously simplifying)  This is a constraint on spending that would not cause a periodic game of chicken, and might actually have some force.