Ron Paul's Modest Proposal

A Monetary Rorschach Test

Is it just an accounting gimmick, or something more?

Ron Paul proposes that the Fed should forgive the $1.6 trillion it is owed by the Treasury, thereby giving the Treasury an additional $1.6 trillion borrowing capacity so as to avoid the looming debt ceiling. Dean Baker then endorses the proposal, Greg Mankiw comments, and the thing goes viral (see here, here, here).

Viewed as a solution to the debt ceiling problem, the proposal is definitely nothing more than an accounting gimmick. The point is that the debt of the Fed, the $1.6 trillion of reserves that currently funds the Fed’s holding of Treasury securities, does not count toward the debt ceiling, while the $1.6 trillion that the Treasury owes to the Fed does. (Fed Balance Sheet is here.)

From a monetary perspective, however, there is a lot more at stake. What you think about the proposal depends on what you think the Fed actually is. Is it a government bank or a banker’s bank or, as I would argue, a hybrid of the two?

If you think of the Fed as a government bank, then you think of the liabilities of the Fed, cash and reserves, as essentially the same kind of thing as Treasury bills, just paying lower interest. The fact that the Fed holds Treasury bills as an asset has no economic importance; it is just a matter of intra-governmental accounting. The fact that the Fed pays its net profits every year to the Treasury, most of those profits arising from the fact that Fed liabilities pay lower interest than Treasury liabilities, shows you that the Fed is essentially a way of providing the government with a cheap form of finance.

If you think of the Fed as a banker’s bank, however, then you think of the liabilities of the Fed as the ultimate means of payment that banks use to settle with each other at the daily clearing. The Treasury securities held by the Fed are the assets backing the value of the liabilities. Forgiving $1.6 trillion of assets would leave $1.6 trillion of liabilities with no backing. The fact that these assets are debts of the Treasury has nothing to do with it; forgiving the $1 trillion of mortgage-backed securities that the Fed also holds would leave $1 trillion of liabilities with no backing. Either way, viewed as a bank, the Fed would be insolvent, and some fraction of its liabilities would be transformed instantly into mere fiat currency.

Which view is correct?

I think we have to say that both perspectives are legitimate, that both capture important dimensions of the hybrid institution that is the modern central bank. In wartime, the government bank dimension tends to be dominant since the government finance problem is dominant. In peacetime, the banker’s bank dimension tends to be dominant as private credit takes on more importance. But both are always in the picture.

So what would happen today if Ron Paul’s proposal were actually to be adopted?

I think markets would probably appreciate that the Fed’s liabilities are in fact backed by the Treasury, even if the actual Treasury securities were no longer in the Fed’s vaults. (Remember, the markets appreciated for years that the GSE liabilities were implicitly backed by the Treasury, an implicit backing that became explicit as a consequence of the financial crisis.) Implicit off-balance sheet backing would thus replace explicit on-balance sheet backing, a step backward in transparency, but otherwise not much economic effect.

So as to remove any possible doubt, I do not favor Ron Paul’s proposal. Transparency is important. Even more, the Fed is too important to be used as a temporary accounting gimmick.

As a banker’s bank, the Fed is the original too-big-to-fail bank, and the only legitimate one.

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