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Chalk this one up to, "Why didn't I think of that?" Ron Paul has proposed a novel solution to the debt ceiling crisis, and I'm having a hard time figuring out the downside (though I know there has to be a downside). Paul's proposal is that we simply erase the $1.6 trillion in debt created by the various rounds of quantitative easing.

You read that right. Just tear up the debt like it never happened, thus buying the government another couple years before the debt ceiling looms again. How could we possibly do that? Well, it turns out we just kinda owe the money to ourselves. So it's like moving the money from your left pocket to your right. Any interest owed by the Treasury Department to the Fed gets refunded anyway, so it's a net breakeven.

The basic story is that the Fed has bought roughly $1.6 trillion in government bonds through its various quantitative easing programs over the last two and a half years. This money is part of the $14.3 trillion debt that is subject to the debt ceiling. However, the Fed is an agency of the government. Its assets are in fact assets of the government. Each year, the Fed refunds the interest earned on its assets in excess of the money needed to cover its operating expenses. Last year the Fed refunded almost $80 billion to the Treasury. In this sense, the bonds held by the Fed are literally money that the government owes to itself.

Unlike the debt held by Social Security, the debt held by the Fed is not tied to any specific obligations. The bonds held by the Fed are assets of the Fed. It has no obligations that it must use these assets to meet. There is no one who loses their retirement income if the Fed doesn't have its bonds. In fact, there is no direct loss of income to anyone associated with the Fed's destruction of its bonds. This means that if Congress told the Fed to burn the bonds, it would in effect just be destroying a liability that the government had to itself, but it would still reduce the debt subject to the debt ceiling by $1.6 trillion. This would buy the country considerable breathing room before the debt ceiling had to be raised again.

So just wiping out that portion of the debt seems like an elegant solution, no?

I can't help feeling a little queasy about it, though. First and foremost, it sure feels a lot like creating money out of thin air. I know that's the Fed's raison d'etre, but this just feels like blatant counterfeiting. Second, Ron Paul is a notorious Fed antagonist. He even wrote the book End The Fed, so he's hardly an impartial observer. I can't help thinking the old codger has an ulterior (though no doubt Constitutionally legitimate) motive in this proposal.

What am I missing here, guys? Can the answer really be this simple? Has Ron Paul single-handedly solved the debt ceiling crisis by sodomizing the Fed for $1.6 trillion (theoretically the Fed is the loser here, because they'd be giving up the assets)?

Some of you might point out that the Fed had plans to sell the assets to the public to tighten the money supply and control inflation, but they can do that simply by raising rates. Is this the perfect solution?

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Comments (51)

  • mxc's picture

    That's exactly why central banks are independent of their government.

  • eokpar02's picture

    That is a great synopsis, but if we keep overspending like we are now, the 1.6 trillion dollars that we wouldn't have to pay the fed, we would still need to raise the debt ceiling next year.

    I am not cocky, I am confident, and when you tell me I am the best it is a compliment.
    -Styles P

  • In reply to eokpar02
    Edmundo Braverman's picture

    eokpar02:
    That is a great synopsis, but if we keep overspending like we are now, the 1.6 trillion dollars that we wouldn't have to pay the fed, we would still need to raise the debt ceiling next year.

    True. But I think the hope is that we'd somehow get our shit together in the meantime. Of course, there's no historical basis for that expectation.

  • HarvardOrBust's picture

    Then commercial banks + other financial institutions walk away with 1.6T? Imagine the outrage.

  • RexAlpha's picture

    There is no debt ceiling solution. A solution for the debts by higher taxation seems to be possible when republicans were excluded from politcial decision making, which is not procurable.

    Since the first gulf war 1991, the debt has more than tripled until now. The USA must change their foreign policy, the current foreign policy is a way too expensive on the long run. Non-interference will be wiser.

    US foreign policy cost factors:

    Operation Enduring Freedom +1 trillion $
    Iraqi War+3 trillion $
    http://www.bloomberg.com/news/2011-07-05/treasurie...

  • In The Flesh's picture

    In all likelihood, that would make the problem worse. Once these politicians and bankers get it into their heads that they can just erase all the debt in a flash, they'll even crazier on QE than they already have. It would be like developing a hangover cure for the central bank. You'll feel better in the morning; until then, go nuts! Who cares?

    Metal. Music. Life. www.headofmetal.com

  • In reply to HarvardOrBust
    eokpar02's picture

    HarvardOrBust:
    Then commercial banks + other financial institutions walk away with 1.6T? Imagine the outrage.

    The 1.6t was bought by the fed, not banks.

    I am not cocky, I am confident, and when you tell me I am the best it is a compliment.
    -Styles P

  • In reply to In The Flesh
    RexAlpha's picture

    In The Flesh:
    In all likelihood, that would make the problem worse. Once these politicians and bankers get it into their heads that they can just erase all the debt in a flash, they'll even crazier on QE than they already have. It would be like developing a hangover cure for the central bank. You'll feel better in the morning; until then, go nuts! Who cares?

    Putting the economy on QE = Giving a drug addict more dope

    short-term effect, long-term hangover

  • In reply to eokpar02
    HarvardOrBust's picture

    eokpar02:
    HarvardOrBust:
    Then commercial banks + other financial institutions walk away with 1.6T? Imagine the outrage.

    The 1.6t was bought by the fed, not banks.

    The Fed holds 1.6T in government securities as assets... which they bought from depository institutions.

    I'm not sure how wiping out 1.6T on the Fed's balance sheet will lower government debt. What would happen to the 1.6T?

  • veritas14's picture

    The Pauls continue to be the only members of Congress with any clue about the workings of the Fed.

    *********************************
    "The American father is never seen in London. He passes his life entirely in Wall Street and communicates with his family once a month by means of a telegram in cipher." - Oscar Wilde

  • The Man's picture

    If this could work then the entire government debt could be erased by having the fed print money to by it all and then burn it. I don't think that is something I want to be possible.

  • MarketParticipant's picture

    I don't fully understand the implications of erasing $1.6T of debt either.

    What I do know is that the Fed had to print $1.6T of money to buy those bonds. What happens to that money if that debt is erased - does it just stay in circulation, or do they recall all of it?

    Also, does the dollar become weaker or stronger if this happens? I would initially think stronger, because there is less debt on the Fed's balance sheet. At the same time (assuming that $ stays in circulation) there is much more money floating around backed by far less credit, so I would think that the dollar would depreciate dramatically.

    Finally, I think the markets and debt rating agencies would take this as a huge sign that the U.S. is no longer good to pay its obligations. Just deciding to erase debt (whether owe to yourself or another party) when it's inconvenient to pay is a slippery slope and could end up screwing us over big-time.

  • Edmundo Braverman's picture

    @MarketParticipant 3 things:

    1) They didn't actually print the money, so it isn't really in circulation. It is literally nothing more than an entry on an Excel spreadsheet for both the Treasury and the Fed. The idea was to spur commercial lending, but that never really happened.

    2) Since the Fed would actually be losing $1.6 trillion in fungible assets off their balance sheet, it has to be a net negative for the Fed. The Treasury's debt is actually a Fed asset, so the destruction of said debt would be a notional profit to the Treasury and loss to the Fed. This is my reading of the situation, anyway.

    3) I think you're absolutely correct here. Even if we have the ability to magically wipe out almost $2 trillion in debt, the ratings agencies couldn't possibly look kindly on that type of workaround.

    The only thing that makes me hesitate to dismiss this idea out of hand is where it came from. Ron Paul is probably the sharpest guy in D.C., and it's difficult for me to believe that he would propose anything that wasn't fiscally kosher. That's just the kind of guy he is.

  • veritas14's picture

    It doesn't erase the long term entitlement debt which MUST be addressed. But it clears the air politically around the debt ceiling discussion (which is mostly a political circle jerk by both Dems and GOPs)

    *********************************
    "The American father is never seen in London. He passes his life entirely in Wall Street and communicates with his family once a month by means of a telegram in cipher." - Oscar Wilde

  • MarketParticipant's picture

    Eddie-

    Thanks for the replies. I agree with your take on #2, and that is what is tough for me to get my head around.

    The Federal Reserve NOTE - is an gov't obligation backed by an asset to one institution that is debt to another gov't institution. So what happens to it's value when the underlying assets/debt are partially wiped out?

    Also agree on Ron Paul. It seems that he's one of the only people (if not THE only person) in Washington with the conviction to discuss and propose the things that no one else will. It's a shame to see the media portray him as an eccentric rather than responsible representative.

  • In reply to veritas14
    eokpar02's picture

    veritas14:
    The Pauls continue to be the only members of Congress with any clue about the workings of the Fed.

    I agree. Paul has an almost eery knowledge about money and how the Fed works.

    I am not cocky, I am confident, and when you tell me I am the best it is a compliment.
    -Styles P

  • In reply to HarvardOrBust
    eokpar02's picture

    HarvardOrBust:
    eokpar02:
    HarvardOrBust:
    Then commercial banks + other financial institutions walk away with 1.6T? Imagine the outrage.

    The 1.6t was bought by the fed, not banks.

    The Fed holds 1.6T in government securities as assets... which they bought from depository institutions.

    I'm not sure how wiping out 1.6T on the Fed's balance sheet will lower government debt. What would happen to the 1.6T?

    I thought they bought it from the treasury, no?

    I am not cocky, I am confident, and when you tell me I am the best it is a compliment.
    -Styles P

  • In reply to eokpar02
    ibintx's picture

    eokpar02:
    HarvardOrBust:
    eokpar02:
    HarvardOrBust:
    Then commercial banks + other financial institutions walk away with 1.6T? Imagine the outrage.

    The 1.6t was bought by the fed, not banks.

    The Fed holds 1.6T in government securities as assets... which they bought from depository institutions.

    I'm not sure how wiping out 1.6T on the Fed's balance sheet will lower government debt. What would happen to the 1.6T?

    I thought they bought it from the treasury, no?

    I don't know the full structure of those issuances, but even if the Fed DID buy them from banks, it's not like those banks just picked them up out of thin air to start with-- the banks bought them from the Treasury first, then probably made a very small profit flipping them to the Fed. So I don't think that is a factor, as those banks have already made their profit either way and are no longer involved. The banks don't owe 1.6T to anyone..the treasury does. So wiping out that debt would help the Treaury, hurt the Fed, and have no effect on private banks.

    Also, at the current rate, 1.6T is only one year's worth of spending deficit. So doing all of this would only postpone this exact situation for one year, while bringing all of the possible negative publicity/ratings effects.

  • alexpasch's picture

    The Fed holds bonds, but those same CUSIPs are held by other non-governmental players. How would you selectively default depending on the owner of the bond? That's the type of shenanigans that gets you a default rating from one/all of the agencies.

    In related news, I really hope the S&P declares Greek debt in default regardless of what shenanigans those Europeans pull. It's ridiculous. It's obvious Greek is going to default, and we should take the pain now. These people are crazy...

    Consultant to a Fortune 50 Company

  • GoodBread's picture

    If I'm following correctly, we're talking about wiping out $1.6T in reserves here right? Just because they're finally understanding that you can't push on a string doesn't mean the Fed should pull on it. The problem with all the mistakes the Treasury and Fed have made it that correcting them too soon would simply make matters worse.

  • In reply to alexpasch
    GoodBread's picture

    alexpasch:
    In related news, I really hope the S&P declares Greek debt in default regardless of what shenanigans those Europeans pull. It's ridiculous. It's obvious Greek is going to default, and we should take the pain now. These people are crazy...

    Agreed. It would be a pretty bad precedent for the CDS market if this wasn't recognized as a default as well.

  • In reply to GoodBread
    alexpasch's picture

    GoodBread:
    alexpasch:
    In related news, I really hope the S&P declares Greek debt in default regardless of what shenanigans those Europeans pull. It's ridiculous. It's obvious Greek is going to default, and we should take the pain now. These people are crazy...

    Agreed. It would be a pretty bad precedent for the CDS market if this wasn't recognized as a default as well.

    Yeah exactly. Why even have CDS at this point? If I owned Greek CDS I would be livid right now...

    If no one in Europe is ever going to default, then maybe selling CDS on all the PIIGS is a great investment right now...

    Consultant to a Fortune 50 Company

  • total's picture

    This would cripple the Feds ability to keep interest rates low by using the proceeds from maturing bonds to purchase more treasuries. The Feds only has a $2.8 trillion balance sheet, so $1.6 is substantial.

  • In reply to alexpasch
    RexAlpha's picture

    alexpasch:
    The Fed holds bonds, but those same CUSIPs are held by other non-governmental players. How would you selectively default depending on the owner of the bond? That's the type of shenanigans that gets you a default rating from one/all of the agencies.

    In related news, I really hope the S&P declares Greek debt in default regardless of what shenanigans those Europeans pull. It's ridiculous. It's obvious Greek is going to default, and we should take the pain now. These people are crazy...

    The whole european parliament seems to be crazy, burning money just for fun.

    Who's next ? Portugal or Spain, maybe Italy ?

    That's a real ponzi scheme, Madoff is just a harmless kid compared to the EU politicians

  • In reply to alexpasch
    roofstreet's picture

    alexpasch:
    The Fed holds bonds, but those same CUSIPs are held by other non-governmental players. How would you selectively default depending on the owner of the bond? That's the type of shenanigans that gets you a default rating from one/all of the agencies.

    In related news, I really hope the S&P declares Greek debt in default regardless of what shenanigans those Europeans pull. It's ridiculous. It's obvious Greek is going to default, and we should take the pain now. These people are crazy...

    i guess we should by some inverse NYSE and NASDAQ ETF's, profit off this looming default!

    "...the art of good business, is being a good middle man, putting people togeather. It's all about honor and respect."

  • loki276's picture

    Will probably have disastrous consequences on the bond markets and pretty sure rating agencies wont look too kindly on this, Will most likely damage the dollars status as well. Too risky me thinks

  • dazedmonk's picture

    Doesn't matter what the Greeks call it for the sake of CDS.

    Unless your CDS was very poorly structured/written, it should be clear what constitutes a default for the sake of getting your money, regardless of what any govt claims

    As to the Fed thing, all that happens is that we withdrew the promise of ever pulling that $1.6T in Fed created money out of the system or replacing it with $1.6T in productivity. This would cause a significant (though how significant I'm not sure) fall in the dollar. If we were expected to pull this shenanigan more than once, the greenback would fall through the floor.

  • dwight schrute's picture

    Accepting that this would work without any credit worthiness effects, it does not address the fundamental problem of deficit creation. Congress, unions, the welfare state, military-industrial complex, and every other interest group would merely view it as a godsend that allows them unlimited access to the treasury's teat.

    Paul is probably hoping that this would undermine international and public confidence in the FED and thus beget a reduction or outright revocation of their powers. Imagine how much gold would spike if this came to pass.

    Making money is art and working is art and good business is the best art - Andy Warhol

  • TNA's picture

    Or maybe we could cut spending and learn to do with less. The economy will eventually rebound and the increased tax revenue, combined with the lower spending levels, will allow us to pay down the deficit.

    Naaaa.

  • brotherbear's picture

    Alright--I'm going to explain some shit here because you all are meant to know something about finance, and there is some real nonsense being spouted here.

    Firstly, Greece should default. The Europeans should be looking for a way to allow Greece to leave the Eurozone without too much trouble, and should use that system to transition the rest of the PIIGS out of the system as well. The idea of a 'two speed' Europe is absolutely true. But the Germans should remember that they're not Greece's saviors. No one has benefitted more from the euro than the Germans, so if they want to let it fall apart, they shouldn't be upset when it turns out that is a big negative for their economy.

    Secondly, the Federal Reserve Bank DOES NOT PRINT MONEY. For the love of whatever god you pray to, learn how the fucking banking system works. That means doing something beyond touching yourself while looking at the Goldman Sachs Careers Website. The U.S. Mint (part of the Treasury) mints coins. The Bureau of Engraving & Printing (also part of the Treasury) prints notes. The Bureau of the Public Debt (also part of the Treasury) issues all debt in the US. The Fed just dicks around with interest rates through open market operations. They control the money supply. And guess what? Each of the 12 reserve banks have to post collateral for the amount of currency they have in circulation. They have done so since before any of us were alive. They do so through purchases of US treasuries and gold certificates, so quantitative easing wasn't even that novel.

    And what's more, the VAST MAJORITY of money spent on QE went to excess reserves at the Fed which all depository institutions have to hold anyway. To be fair, most are now holding reserves far in excess of what is required by law, but that was exactly the point. QE didn't come into existance to increase lending and free up the credit markets. At least, that wasn't the only purpose. It also allowed banks to shore up their balance sheets and prepare for upcoming changes to capital requirements in Basel III and Dodd-Frank. That's why QE and QE2 didn't actually do anything to spur lending.

    Now, Ron Paul's plan--it sucks for a lot of reasons, the main one being the fact that U.S. Treasuries held on the Fed's balance sheet are ASSETS. Excess reserves held at the Fed by depository institutions are LIABILITIES. If you simply wipe clean the assets on their balance sheet, but maintain the liabilities, the Fed would become insolvent. And, since the Fed DOES NOT HAVE THE ABILITY TO PRINT MONEY, it cannot print its way into balancing its accounts. Ergo, it would have to do one of two things: ask the Treasury to print more notes to simply give them or return the excess reserves to US depository institutions. The former is the EXACT SAME as the U.S. Treasury printing money in the Bureau of Engraving and Printing and buying treasuries from the Bureau of the Public Debt. THAT is printing money, and it's immediately dilutive to the strength of the US dollar.

    The latter case is far more plausible, though exceptionally unpalatable. The Fed could return excess reserves to depository institutions, though it has never before done so. That would basically be the same as a complete unwinding of QE1 & QE2 all at the same time (since, as I said above, most of QE resulted in stockpiling of excess reserves held at the Fed). Think of it this way--mostly, the Fed is meant to slap the markets around a bit through open market operations. That implies buying or selling treasuries in exchange for cash. It's how they control the velocity of money. Returning excess reserves to banks to eliminate balance sheet problems through wishing away the Fed's assets is the exact same as selling a shitload of treasuries all at the same time.

    And I'm not wrong on this. The $1.6 trillion of debt we're talking about the Treasury owing the Fed. It's entirely comprised of excess reserves. Take a look at this:
    http://www.fixedincomelive.com/2011/06/07/where-oh...

    $1.6 Trillion in excess reserves at the moment. Not a coincidence.

    As such, QE actually REDUCED the velocity of money in circulation. But it had all of you short bus-riding, extra chromosome having Neanderthals thinking it did the opposite. It's because you fools learn your finance from CNBC. The people on camera aren't meant to know much. Not really. Do your homework. I'm actually really angry with the utter lack of knowledge I've seen in these posts.

    We were talking about a VERY simple balance sheet issue. All of you should have been able to figure this out. Read a fucking book.

  • In reply to brotherbear
    ck123321's picture

    brotherbear:
    That means doing something beyond touching yourself while looking at the Goldman Sachs Careers Website.

    ey,

    I also take a dump while looking at the GS Careers Website

  • In reply to ck123321
    dwight schrute's picture

    ck123321:
    brotherbear:
    That means doing something beyond touching yourself while looking at the Goldman Sachs Careers Website.

    ey,

    I also take a dump while looking at the GS Careers Website

    simultaneously? that takes talent.

    Making money is art and working is art and good business is the best art - Andy Warhol

  • In reply to Edmundo Braverman
    ck123321's picture

    Edmundo Braverman:
    dwight schrute:
    ck123321:
    brotherbear:
    That means doing something beyond touching yourself while looking at the Goldman Sachs Careers Website.

    ey,

    I also take a dump while looking at the GS Careers Website

    simultaneously? that takes talent.

    Golden blumpkin? Sort of?

    yup, Goldman blumpkin, best kind for sure. try it!

  • In reply to eokpar02
    mfoste1's picture

    eokpar02:
    HarvardOrBust:
    Then commercial banks + other financial institutions walk away with 1.6T? Imagine the outrage.

    The 1.6t was bought by the fed, not banks.

    the fed IS the bank, fucking dumbass.

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    HedgeTed's picture
  • eokpar02's picture

    I am not cocky, I am confident, and when you tell me I am the best it is a compliment.
    -Styles P

  • In reply to eokpar02
    HedgeTed's picture

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