If the Fed Will Play Along, the Options Improve

-- Posted by Neil H. Buchanan

My Dorf on Law post this past Friday began with a discussion of how the Federal Reserve (the Fed) works, in order to explore some of the options available, should the U.S. ever reach the actual drop-dead date on the debt ceiling.  In the latter part of the post, I compared two unappealing policy paths that a President might follow in that situation: (1) the Big Coin gambit (minting large-denomination platinum coins), or (2) simply ordering the printing of more currency with which to pay the government's bills.  I ended up (very reluctantly, and only if the choice was between those two terrible options) arguing that the Big Coin gambit was actually better than printing money.

There are some fun logistical issues that also contribute to that conclusion, which I might describe in a future post.  Right now, however, I want to pay closer attention to a distinction that I mentioned in passing on Friday, in order to work through how the Federal Reserve's decisions ultimately determine how to choose among the unpalatable options available to a President who is facing a possible default.

At its core, my reluctant choice of Big Coins over illegal currency was based on the public's possible reaction to each possibility.  As absurd as the minting of trillion-dollar platinum coins would be, no individual would be forced to accept such a coin in payment on an obligation.  Instead, under the Big Coin gambit, the President would have the Treasury mint some arbitrary number of such coins, the nominal values of which would add up to an amount sufficient to substitute for the borrowing that would normally have occurred, had there been no debt ceiling problem.  The Treasury would then send out checks to its obligees, and the Fed would stand behind those checks, verifying that the Treasury's checks would not bounce.

This situation would still be crazy, of course, because everyone would wonder why the Fed had accepted novelty coins as being worth trillions of dollars.  But as a matter of the day-to-day functioning of our economy, nothing else would appear to be unusual to the typical person on the street.  By contrast, if the President were to order the government's bills to be paid with newly-printed currency, people everywhere would suddenly be on high alert, wasting huge amounts of time trying to be sure that they were receiving only the older, "real" money, not the illegal new "funny money."  This would, it seems to me, be much more likely to create serious damage to the economy.

Remember, what we are discussing here is illegal.  There is a statute through which Congress ordered the President to mint coins, and the supposed loophole in that law simply does not provide the escape hatch that its proponents claim.  (Professor Dorf and I have each offered independent reasons why the platinum coins are not "perfectly legal."  See here and here, respectively.)  Similarly, there is a statute ordering the President to produce currency, but to do so under conditions that prevent him from simply using newly-printed currency to carry out appropriated spending.

Therefore, the government would still be in default, because the President would be paying the government's bills with illegal tender.  (By contrast, issuing debt in excess of the statutory limit is not a default, because in that situation we would have investors who are willing to lend the government legal money in return for a risky promise to be paid later, at risk-adjusted interest rates.)

Notice, however, that the key distinction between the Big Coin gambit and printing new currency is not really the difference between the platinum coins and the paper dollar bills, but the Fed's role in dealing with the crisis.  If the Fed refuses to accept the platinum coins for deposit in Treasury's account, the gambit simply fails.  If the Fed accepts the coins, however, then the rest of the system can work as it always works.

Recognizing this, the President would notice that he could simply skip the silly step of minting platinum coins, and instead order the printing of new currency -- but rather than paying the government's bills directly with the new cash, he could have that currency deposited with the Fed.  The rest of the financial system (which barely uses currency these days, in any case) would then work in the same way that it always does, but without the added absurdity of the Big Coins.  And that would, indeed, be a better approach.

At this point, however, it becomes obvious that there are clearly superior ways to handle this situation.  If the Fed is willing to accept currency or platinum coins, after all, then why would it not want to handle things in the way that would be least disruptive to the economy?  And that would be to skip both the platinum coins and the new currency altogether.

For the Fed to play along, it would have to decide to exercise its independence in a way that violates its own charter, which would threaten the very independence that it enjoys at the discretion of Congress.  This is all very risky political terrain.  Still, if the Fed were to decide (reasonably, I think) that its ultimate legal obligation is to guarantee that the financial system is not seriously damaged by a government default (or a catastrophic loss in confidence in the financial system), what could it do?

In its normal operations, when it regulates the supply of money, the Fed generally goes into the private financial markets and purchases or sells Treasury bonds.  (The Fed is independent from the Treasury.  The Treasury creates the bonds in order to borrow money, and it makes the principal and interest payments.  The Fed, in this context, is just like any lender to the federal government.)  By purchasing Treasury bonds, the Fed increases the amount of money that exists, because people receive new money from the Fed when its buys the bonds that people no longer wish to own.  (Technical point: There is a "money multiplier," which is not relevant to this analysis.)

Even when the Treasury is issuing new debt as part of its normal operations, the Fed need not buy the Treasury's new bonds directly from the Treasury itself, because the Fed only cares about the total amount of bonds that it buys and sells.  Whether those bonds are old or new is beside the point, because all of the bonds are legally equivalent.  That is, even though the bonds have different maturity dates and so forth, they are all backed by the full faith and credit of the federal government.  Therefore, the Fed would be perfectly willing to allow the Treasury to sell new bonds to the public, with the Fed buying old bonds from other members of the public.  What matters is the aggregates, not the specific issue dates of the bonds.

In our hypothetical world where we have hit an absolute debt ceiling, however, issuing new debt is illegal.  We worry that the world at large will not accept Treasury bonds that have been illegally issued (in excess of the debt ceiling), because the world knows that Congress might ultimately not validate those bonds.

If the Fed will play along, however, things can function much more smoothly.  The Fed could simply arrange to buy the "rogue debt" directly from the Treasury, on the understanding that this will put enormous pressure on Congress ultimately to treat the illegal bonds as valid.  In the meantime, admittedly, the financial markets will start to go a bit haywire, because of concerns about all of the illegal actions being taken (and concerns -- misplaced concerns, but predictable ones -- that this will be inflationary).

In other words, if the Treasury needed to borrow, say, $100 billion, it could simply issue new bonds and sell them directly to the Fed.  The Fed would then hold those bonds, crediting the Treasury's "checking account" with an additional $100 billion, which could then be used to pay bills.  The legal invalidity of the new bonds would be known to the markets, and would have secondary effects on confidence and such things, but it would not matter to the Fed.

At this point, however, the Fed could simply admit that following the usual accounting conventions has become entirely unnecessary.  It could say, "We hereby give the Treasury $100 billion, which we will take back when it makes sense to do so."  That would be an "obligation," in the same way that I argued last month that the platinum coins themselves would be an obligation -- which is to say that, as a matter of substance, the Treasury would owe $100 billion, even though it had not issued formal Treasury bonds in that amount.

However, people who were unconvinced by my substance-over-form argument about platinum coins might really like this option.  Without doing anything cartoonish, the Fed could say that it is "giving" the Treasury money, to be repaid at a later date, all the while denying that this is a legal obligation.  For those of us who would find that distinction meaningless, this would still be the better option, because it would be the cleanest way for the Treasury to violate the debt ceiling, which is what must happen under the Buchanan/Dorf trilemma analysis that motivates this entire discussion.

Another way to think about all of this is that the Big Coin gambit -- even if it were legal for the President to have platinum coins minted -- would only work if the Fed agreed to take actions that it would not otherwise take.  If it were willing to agree to those extraordinary actions, however, it would be much better for the Fed to dispense with all of the nonsense and simply increase the number of dollars that exist electronically on the Treasury's account.  No coins need be minted, no currency need be printed.  Indeed, no actual Treasury bonds would need to be issued.  If the Fed is game, then the logistics become rather simple.

This is not to say that any of these are good choices.  The Fed would have to violate its own understanding of its legal authority in order to do any of these things.  It would be a terrible idea for future Congresses to think that the debt ceiling need not be increased or repealed, and that the Fed can just take care of everything.  Confidence in the legal functioning of our financial markets is an essential element of stability and prosperity.  If Republicans' radicalism succeeds in holding the economy hostage, the Fed can and should do what it can to reduce the damage.  There simply need be no damage in the first place, however, if the Republicans would only stop taking hostages.  The debt ceiling has never served a purpose, but at least it used to be harmless.  Now, its only possible use is as a weapon of mass destruction.  This must stop.