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Central Banks and Budget Deficits

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Dean Baker
International Relations and Security Network, July 6, 2011

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Ron Paul is a long-serving representative in the U.S. Congress. He is a committed libertarian who is now embarking on his third presidential campaign. He has built up a devoted political following over the years.

While many of his ideas are outside of the mainstream, that doesn’t mean that they do not deserve to be taken seriously. As a solution to the impasse over the debt ceiling in the United States, Mr. Paul suggested that the Federal Reserve Board destroy the $1.6 trillion in government bonds that it currently holds. This act would put the government far below its $14.3 trillion debt ceiling providing perhaps two more years before any action needs to be taken to raise the ceiling again.

Destroying $1.6 trillion in government debt might seem far-fetched, but it actually makes a great deal of sense. The Fed acquired this huge stock of debt through its policy of quantitative easing. This was an effort to try to provide further stimulus to the economy once the short-term lending rate had already been pushed to zero. Since the short-term rate could not go any lower, the Fed bought up several trillion dollars of mortgage-backed securities and government bonds in order to directly lower long-term interest rates.

While the mortgage-backed securities are debt from private parties to the Fed, since the Fed is an agency of the U.S  government, the bonds held by the Fed are literally money that the government owes to itself. In fact, each year the Fed refunds back to the Treasury the interest earned on its assets in excess of its operating costs. This means that the interest that this is paid on the bonds held by the Fed is effectively interest that the government is paying itself.

In this context, it is very difficult to see any downside in eliminating a bookkeeping entry. The Fed would lose $1.6 trillion in assets and the government would lose $1.6 trillion in liabilities and suddenly be far below the debt limit.

In addition to the short-term benefit of getting around the standoff on the debt ceiling, this move also has the great long-term benefit of reducing the government’s future interest burden. While the bonds do not create any net interest burden as long as they are held by the Fed, the plan is for the Fed to sell them off as the economy recovers. The Fed would do this to pull reserves out of the banking system, limiting its lending ability and thereby preventing inflation.

Once the bonds are in the hands of the private sector, they do create an interest burden for the government. While the Fed is currently expected to refund $80 billion to the Treasury in 2011, in 2017 it is projected to refund just $33 billion. The difference of $47 billion is lost revenue to the government.

However if the Fed destroys the bonds that it currently holds then the interest on this debt can never be a burden to the government. The bonds would cease this exist.

This would mean that the Fed would not be able to sell bonds to pull reserves out of the banking system. However it can accomplish the same result with a different tool. It can simply raise the reserve requirement, forcing banks to hold a larger fraction of their deposits on reserve.

Raising the reserve requirement can be just as effective as reducing the quantity of reserves in limiting lending. If the amount of reserves in the banking system is doubled, and the reserve requirement is also, then the banking system will just be able to make the same amount of loans. The big difference between these two paths is that the government would not have to pay as much interest on its debt, in the case where the volume of lending is limited by higher reserve requirements.

This is in effect exactly what we should want to see in this situation. The reason that the U.S. government and other governments are running large deficits is because of the collapse in private sector spending. The deficits are supporting output and employment by filling the gap in demand. In normal times, deficits may be pulling away resources from the private sector and crowding out investment; this is not the case in the downturn. The deficit is sustaining demand and therefore most likely increasing private sector investment.

The one downside to this story is that the deficit is creating a tax burden for the future. However if the government destroys the debt issued to finance its spending in the downturn, then the debt need not ever pose a tax burden.

The idea of effectively getting money for free may seem peculiar, but that is exactly the story of an economy that is below its full employment level of output. In such circumstances, the economy is not supply constrained. If there is more demand, there will be more output. The real waste in this context is the failure of the government to spend. In that case workers who have the skills and desire to work go unemployed and factories and other facilities go idle.

Representative Paul’s proposal provides exactly the sort of mechanism that we should want to see in this situation. It allows the government to generate the demand needed to push the economy back toward full employment, without creating a major debt burden for future generations of taxpayers.

Now, this may not be exactly how Mr. Paul viewed his proposal. After all, he has a long history of hostility to the Fed as an institution. Two years ago he wrote a book titled End the Fed. But Mr. Paul’s motives don’t matter. This is a proposal that deserves to be taken seriously not just for the Fed, but by other central banks as well. The debt incurred to boost economies out of recessions should not place a burden on future taxpayers and we know how to prevent this from happening.


Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of The End of Loser Liberalism: Making Markets Progressive. He also has a blog, "Beat the Press," where he discusses the media's coverage of economic issues.

 

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