On the comments board for two of my recent posts about the debt ceiling ("A Priority List of the Available (All Bad) Choices in the Upcoming Deadlock," January 16), and "The Limits of Political Framing, or: How Many Fig Leaves Can Senator McConnell Create?" January 24), a reader with the well-chosen internet handle "curious" posed some very good questions. On the earlier post, the questions were:
"Why isn't the Federal Reserve subject to the debt ceiling? Where does the Fed get the money from to exchange for Treasuries or platinum coins or to purchase other bonds or otherwise engage in QE or monetary policy generally?"On the second post, the questions were:
"Why would the Federal Reserve get the trillion dollar coin?Questions like these are a very good argument for the existence of comments boards. Among other things, it is a useful reminder to an old macroeconomist like me just how much of what I take for granted is not obvious to normal human beings. It is also an interesting argument for cross-disciplinarity, because some of those questions are nearly impossible to answer without some combination of training in legal matters and economic theory. In any case, I will try to answer all of the questions above, although I will not do so in the order in which they were posed (because many of the issues overlap).
"Why can't the government just use the coin to pay its bills directly?
"What is the Federal Reserve? And why isn't it the Federal Reserve subject to the debt ceiling? If its not part of the Federal government, how does the Fed engage in monetary policy otherwise? (Ok those last 2 questions were mine but I figured it was worth asking again since this was a related entry :)) "
First, the institutional basics. The Federal Reserve (the Fed) is the central bank of the United States. It is not called simply "The Bank of the United States" because of the odd history of the First and Second Banks of the United States, during the early years of the Republic. Even so, the Fed is the U.S. equivalent of the Bank of England, the Bank of Japan, and (before the creation of the euro) the Banque de France and the Bundesbank. (Because the EU is not really a sovereign nation, the European Central Bank has some odd aspects to it, but it is essentially the current European version of the Fed.) Congress, delegating its constitutional power to regulate money, created the Fed a century ago.
The Fed is, among other things, the bank through which the U.S. Treasury conducts its business. That is, because the Treasury does not want to send cash or coins through the mail, it needs to have a bank account against which it can write checks. That account is held at the Fed. The Fed thus clears the checks that Treasury writes, debiting the Treasury's account as checks are cleared.
The Fed's balance sheet includes among its assets the Treasury securities that the Fed buys on the financial markets. It does this to create money, that is, to credit the holders of Treasury securities with electronic entries on their banks' ledgers, which allow those people to turn around and write checks of their own. For example, if I sell the Fed a $10,000 Treasury bond from my portfolio, my bank will credit my account with a $10,000 deposit from the Fed. If I then spend $10,000 on a used car, my bank will verify that the money exists, because the Fed put it there.
This is why it is accurate to say that all money is "created out of thin air." (Note: Even with a gold standard, unless people literally transact all business with physical gold pieces/coins, this works the same way.) The Fed simply writes checks in the amounts that it deems appropriate to regulate the value of money (that is, interest rates), and that money comes into existence.
So, this explains several of curious's basic queries. The Fed is not subject to the debt limit because it is not issuing debt at all. It is, in fact, buying and holding the Treasury's debt, which allows the Fed to fulfill its constitutionally-delegated duties to create and regulate money. It creates money by saying that it has created money. People accept that it has done so, because everyone knows that everyone else accepts that it has done so. That is why, in a previous post, I described money as a "group delusion." It really is a matter of group psychology. Everyone knows that everyone else is happy accepting pieces of paper (or electronic entries) as substitutes for barter, which gives everyone confidence that they can accept those things, too. (Again, gold or any other commodity works the same way. If people stopped accepting gold in payment, very few people would have anything useful that they could do with gold per se.)
Formally, the Treasury prints currency and mints coins. Even that, however, does not diminish the Fed's ability to "control the money supply," because it can buy and sell Treasury bonds in amounts that can offset any changes in currency and coins. (Side note: The Fed's policy discussions revolve around setting interest rates, but they carry out those policy decisions by buying and selling Treasuries, which changes the money supply.)
The other questions that curious asked are related to the "platinum coin" option. The statute that gives the U.S. Mint the legal authority to mint coins limits their amount, denomination, etc. The statute is, however, silent with respect to amounts and denominations of platinum coins, which the law authorizes for commemorative purposes. [Update: Professor Dorf reminded me, via today's comment board, that the relevant statute also allows the minting of coins for the purpose of earning profits for the government, i.e., seigneurage. I hereby acknowledge my error of omission, which does not change any of the analysis here.] Professor Dorf and I argued in various posts last month that it would, in fact, not be legal for Treasury to use that statute's silence as a "perfectly legal" way to get around the debt ceiling. If we are wrong, however, how would it work?
I have not heard anyone else raise one of curious's possibilities, which is simply to use platinum coins to pay Treasury's bills directly. That is, Treasury could supposedly send its obligees envelopes containing newly minted platinum coins, denominated in various amounts sufficient to meet the obligations that it would otherwise not be able to meet (due to the debt ceiling, combined with inadequate tax revenues).
Although this would sidestep the Fed entirely, it would also raise some extremely difficult problems. First, the actual minting of the coins would be time consuming, expensive, and physically challenging. It might not even be possible to mint enough such coins in time to meet the obligations. Second, the public could reasonably wonder whether anyone else will accept the platinum coins as readily as they accept other forms of payment. Because of the group delusion problem, people might not be willing to accept the coins in transacting business. (Think of an enormous expansion of the $2 bill problem. Even though it is legal tender, people often refuse to accept $2 bills.)
This is why the platinum coin option is usually described as minting one or two platinum coins, denominated in some huge amount (one or two trillion dollars), and "walking the coins over to the Fed." This would be the equivalent of an individual walking into her bank and putting some coins on the counter, to be deposited into her checking account. If the bank accepts the coins, the person can then write checks that will not bounce. If the bank does not accept the deposit, then the customer cannot write checks.
The Fed, therefore, would have to play along with the Big Coin gambit. Treasury cannot (unless it pays its bills directly with lots of smaller-denomination platinum coins, as above) do this on its own. Treasury's checks could start bouncing, which is a sure way to destroy the full faith and credit of the United States government.
All of which raises a question raised in comments on my posts from Paul Scott: Why not just issue currency? That is, if we are going to do something illegal (because we are in a trilemma or multi-lemma), then why not just do the thing that Treasury can control, and that the public is the most likely to accept: print money that looks like all other money? Again, that would be illegal, but he is right to set that issue aside, under the hypothetical circumstances where Republicans have really forced the President's hand by refusing to accommodate Congress's own spending decisions.
I understand that reasonable people can differ about the potential damage from undermining the public's group delusion about the existence of money. Even so, I think the discussion above helps to clarify why it is potentially disastrous to force the public to think -- almost certainly for the first time, for most people -- about the fact that money has no intrinsic value. My argument in previous posts was that being blatant about it -- that is, telling people that the government is exploiting a gap in the law to create trillion-dollar platinum coins -- could lead people to lose confidence in the financial system, leading to who-knows-what (hoarding, bartering, and so on).
If that sounds too apocalyptic, I understand. Even so, after years of being an economics professor, and especially after trying to explain in public speeches how the financial system works (even in smaller doses, such as explaining the Social Security trust funds), I do not think it is possible to overestimate just how blissfully ignorant the public in general is about the legal fictions that constitute the monetary system. Even the brief public discussion of platinum coins found news outlets trying to estimate how big a platinum coin would have to be, to be worth a trillion dollars. Telling people that the metal in a quarter-dollar coin is not really worth twenty-five cents, either, is exactly what we do not want to have to explain.
But that is not really responsive to Paul Scott's suggestion: Just print dollar bills, and forget about the platinum silliness entirely. My concern about that option, however, is similar to my concern about undermining the group delusion. Do we really, for example, want tens or hundreds of millions of people checking websites (that would surely spring up immediately) to check the serial numbers on all of their currency, to make sure that it is "good money"? Do we then want them to start to ask why the good money is good in the first place? Even if they do not ask the latter question, however, the consequences of putting out "illegal currency" are no minor matter.
I am unsure about whether the public's confidence would be more severely shaken by the farce of the platinum coin option, or the issuance of illegal dollar bills. Because the public would not directly deal with anything like "fake money" in the Big Coin gambit, I would tend to reluctantly favor that route (if the choice was really that limited -- which it is not). I do concede, again, that this is a close call.
On the other hand, the option that Professor Dorf and I have endorsed from the beginning -- issuing "illegal Treasury bonds," if you will -- appropriately places the risks on the group of people most capable of dealing with risks. Potential buyers of such bonds would not be forced to do so, and their willingness to pay would reflect their assessment of how likely it is that Congress would not ultimately grant retroactive legal status to the illegal bonds. The procedure for selling the bonds is also already in place, and would involve simply doing what would have been done if the debt ceiling had been increased as needed.
Another important side benefit of our preferred approach is that it would make it easy to determine the ultimate cost to the federal government of having actually hit the trilemma. We can easily compare the interest rates paid on legal versus illegal bonds, to compute (at least as a rough cut) the cost of the hostage-taking nonsense by the Republicans. The costs of issuing Big Coins, or illegal cash, would be much more diffuse, and thus much harder to measure. Again, however, this is not the main reason for going with illegal Treasuries.
I hope that all of this remains hypothetical. In any case, I hope that these thoughts are responsive to the questions asked. Even if I cannot convert everyone to our point of view, teasing out these issues is extremely helpful.