The Debt Ceiling, a Trillion Dollar Coin, and Our Children's Future

by Hendrik Van den Berg
UNL Professor of Economics

Even with Congress’ three-month lifting of the debt ceiling, sometime this spring we will again bump into this arbitrarily set limit on how much total debt the U.S. Treasury is allowed to incur. Congress has routinely voted to raise the ceiling, but each vote to raise the ceiling meant politicians could again argue about raising the debt limit a few months or years later. To many people, the debt ceiling debate may seem like just another contrived case of partisan posturing. Unfortunately, the argument over the debt ceiling has grave implications. This brief explanation of the debt ceiling will take you into politics, modern money theory and our children’s future. So, yes, the stakes in the debt ceiling debate are high.

First, Some Background on the Debt Ceiling

Here in the United States, we have separated the government ‘budgeting process’ from the closely related ‘borrowing process.’ Congress first passes spending and taxation legislation, which effectively determines how much the Treasury must borrow to cover the obvious difference between the two. And then it conducts a separate vote to give permission to the Treasury to actually borrow the money Congress effectively already decided would have to be borrowed when it authorized spending and taxes. Most sane countries recognize that the two steps cover exactly the same ground, so they only require one legislative act. But, our politicians love how the duplicate votes on the debt allow them to double their political posturing.

Oh, yes, I should point out that aside from borrowing, there is one other way for the government to cover the difference between government spending and tax revenue: print money. But we do not permit the government to operate in that fashion—allegedly out of fear that the government would print too much and cause inflation. On the other hand, like nearly all other countries, we have a central bank that can in fact print money in any amount it desires. In general, printing money is a normal activity for any government to undertake. Virtually every government in the world does it (with the notable exception of the European Union, which has designated the “European Central Bank” to issue a regional currency called the ‘euro’, with predictably adverse consequences). In the U.S. since 1913, we have given the government’s Federal Reserve Bank a monopoly on creating money. The alternative to a central bank is to let the private financial industry create money, but this invariably generates unstable financial conditions, and—as one might expect—redistributes income towards the already wealthy.

And, Some Financial History

Before Congress authorized the Federal Reserve Bank a century ago, the money supply consisted of (1) Treasury notes printed in exchange for gold or silver sold to it by miners, exporters, hoarders, etc. and (2) privately issued pieces of paper (bank notes) and checking deposits issued by banks and other private financial firms. For brief periods in the mid-1800s, the government also issued paper ‘greenbacks’ to directly fund the war, the transcontinental railroad, and other government expenditures, but later in the nineteenth century, financial interests got Congress to ban such government-created money. All of these forms of paper money were thought to have some specific value because they could be used by ‘borrowers’ of such paper to pay taxes to the government or to repay their obligations to banks or financial firms. Since others who came into possession of such paper could also use it to pay taxes and loans (or exchange it for some other asset deemed to have a value equal to the stated value on the paper—such as gold, silver, or perhaps government Treasury bonds), these pieces of paper were accepted in payment for goods and services throughout the economy. In short, they were indeed money.

The most unstable and dangerous scheme of the three above is the money created by the private banking system. Privately issued money constitutes something of a house of cards. First of all, there is really no clear limit to how much private paper the whole financial system can create. It depends on how much of this paper people are willing to hold and use as money. That is, every dollar lent out eventually comes back to the banking system, ready to be lent out again. For instance, if someone wants to borrow a dollar, the bank creates it by crediting an account or issuing a banknote. The money supply increases accordingly. Then, if that dollar is used to repay a loan, the supply of money in circulation declines by one dollar.

The private money system is inherently unstable because if, say, one of the banks that issued paper goes bankrupt so that its notes are no longer redeemable for cash or gold in its vaults, then the paper in circulation loses its value and the money supply effectively declines. Because banks issue many more notes than they hold valued assets in their vaults (largely because people take their borrowed dollar notes and spend them), the mere suspicion that some banks may not be able to provide gold coins or Treasury bonds to cover the paper obligations will trigger ‘a run on the banks.’ In such a common case, many banks then default, thus creating a bunch of worthless paper and a sharp decline in the money in circulation. In the nineteenth century, such financial ‘panics’ occurred frequently. In each case, bank lending stopped, the money supply contracted sharply, no one had money to spend, and the economy fell into a depression. William Jennings Bryan’s 1896 presidential bid—coming at the end of a long and deep depression—was largely a protest to this precarious monetary system.

The Federal Reserve Bank

In 1913, the Federal Reserve Bank was created to effectively monopolize the process of creating money and to create some stability in the U.S. monetary system. To be effective, the Fed would have to manage money in such a way that interest rates (the cost of borrowing money) and the total supply of money remained relatively stable relative to the overall economy. The Fed’s money was deemed valuable because it was required for paying taxes to the U.S. Treasury, and by law deemed as legal tender to settle any and all debts and obligations. Nearly all countries of the world now let their central bank monopolize the issuance of money.

There are admittedly some potential problems with having the Fed issue money. Because it could print or electronically create and spend too many dollars, it could easily create inflation. But if the Fed can be instructed to only add dollars when there is excess productive capacity and unemployment, then inflation will not be a problem. A more serious problem is that the Fed, although a federally chartered organization with its officials appointed and confirmed by the president and congress, was largely designed and is still operated to serve the financial industry. That is why, for example, it injects money into the economy by using the dollars it creates (with a few computer clicks) to buy Treasury bonds in the privately operated bond market. The cash then ends up in the accounts of whoever sold the bond to the Fed, and thus the amount of money in the private financial system is larger. The hope is that this money then leads banks to lend, people to buy things, and businesses to employ people in new investments. On the positive side, the money the Fed creates for the financial sector to use and expand upon is tightly controlled to keep the money supply stable—far more than if the industry were trying to manage the supply itself. The financial sector, after all, didn’t particularly enjoy the repeated financial crises in the nineteenth century either, and it recognized the need for a central bank to maintain financial stability and to provide free money when things got rough. In short, while the Fed is a government institution, it was largely designed by private financial interests.

I should point out that when the Fed buys Treasury bonds in the open market, it ends up earning the interest on those bonds, and it returns all that interest to the Treasury every year since it is not a for-profit bank. And if a bond matures while held by the Fed, that money paid to the Fed by the Treasury is also returned to the Treasury. But, at the same time, the law requires the Treasury to sell new bonds on the open market to finance its budget deficits, and the Fed can only acquire those bonds in the open market. It would, of course, be cheaper for the Fed to just give the government cash, thereby avoiding the transaction fees paid to private bond dealers and adding to the government’s accumulated debt to private bondholders.

Lately, however, the Fed has moved even further towards serving the broader private financial sector by engaging in a much wider form of monetary expansion called ‘quantitative easing’ (QE), where it buys not only Treasury bonds, but a great variety of assets from banks and other financial groups. The alleged purpose of QE is to not only keep interest rates low and thus induce more lending and investment, but to strengthen bank balance sheets by replacing questionable assets with newly minted cash.

A Trillion Dollar Coin

No doubt by now you’ve heard that the White House could circumvent the whole debt ceiling problem by issuing a platinum coin and having the Federal Reserve buy it in exchange for newly printed cash. Thus, the government would get cash without issuing new debt, and budgeted expenditures in excess of tax revenues could be met without puncturing the debt ceiling. A couple of weeks ago, the White House explicitly rejected the coin as a solution to the debt ceiling, even though Nobel Prize-winning economist Paul Krugman pointed out that the coin gimmick could indeed work as claimed.

Despite a 1982 law restricting the Treasury’s ability to mint coins, the law does allow the Treasury to mint unlimited amounts of platinum coins (apparently as commemorative tokens to celebrate certain patriotic events). Such commemorative coins usually state a nominal dollar value that is unrelated to the actual value of the platinum in the coin, so there is no reason the Treasury could not print $1 Trillion on the face of a small platinum coin.

At the same time, the Federal Reserve Bank can create as much money as it wants, and it can use that money to buy anything it wants for whatever it wants, as its QE activities attest. So, if Congress has not challenged the Fed for purchasing corporate stocks, corporate bonds, ‘collateralized real estate debt obligations’ (CDOs), and other lousy assets to clean up bank balance sheets, why could the Fed also not just buy a beautiful platinum coin from the Treasury for $1 trillion? In this way, while the Treasury cannot borrow directly from the Fed, it can sell something to the Fed. By doing this, the Fed would create new money to pay the Treasury $1 trillion, which it could then use to write Social Security checks, military paychecks, and interest on its outstanding bonds—all without adding to its debt because it does not borrow.

The only snag is that, apparently, the Fed will not go along. But why would the Fed refuse to go along with this, if it is already more than willing to buy bad assets from banks? Remember, the Fed routinely creates new money as the economy expands the amount of transactions carried out. The only difference with the trillion dollar coin scheme is that the Fed would give the new money to the Treasury to spend, rather than giving it to banks, insurance companies, and the wealthy individuals who sell their assets to the Fed in the hope that they will again spend the money in some way that stimulates the economy.

It’s Elementary Monetary Theory!

It is difficult for people to grasp that printing money is neither dishonest, nor economically harmful. But, yes, the government can indeed create money out of thin air. That is actually a good thing because new money must continually be created to keep the money supply in line with overall economic activity when the economy is growing, and it is needed to stimulate economic activity when the economy is crashing. Letting the private financial sector create the money tends to lead to overexpansion during good times and rapid contraction of money when times are bad—exactly the opposite of how the money supply should be managed. There is no obvious reason why banks should get to spend free money instead of the government of the people, for the people.

Government Debt and Income Redistribution

Government debt is not harmful, per se, nor is debt, in general. Since ancient times, humans have incurred debts and obligations. After all, what are social obligations, if not implicit debts? There are times when borrowing is better than starving or dropping out of school. However, financial debt does tend to redistribute wealth from the poor to the wealthy. And, because debt repayments exceed initial lending by the amount of interest paid over time, creditors gain at the expense of debtors. In the case of government debt, taxpayers effectively pay the interest on the public debt. Since most government debt is owed to Americans, most government debt represents payments by future U.S. taxpayers to U.S. bondholders. There are some foreign bondholders as well, and this represents a net loss of interest income to the country. But, government debt represents mostly future tax payments by middle-class taxpayers to make payments to the relatively wealthy Americans who hold most of the Treasury bonds directly or indirectly through various funds, trusts, and financial firms. Therefore, the rise in government debt worsens future income distribution in our country.

On the other hand, using the Fed’s printing press to transfer money directly to the government in exchange for a token platinum coin rather than continuing to force the government to borrow from wealthy people would eliminate this redistribution. Overall, with less explicit government debt, fewer future tax revenues will need to be transferred to the wealthy in the future. Of course, to keep the amount of money under control, the Fed will have to offset this new money creation by engaging in less QE activity. This shift in Fed monetary policy would constitute a potential loss to banks and wealthy asset holders. Also, the financial sector loses the income from transacting the Treasury bonds and bills that would otherwise be issued if Congress simply raised the debt ceiling. Most important, perhaps, is that by having the Fed directly provide prudent amounts of money (as long as we have unemployment and excess capacity) to the Treasury and avoiding further debt increases, anti-government ideologues would no longer be able to use the debt ceiling and the fear of debt to justify further cuts in our already insufficient social safety net.

So Bring On the Trillion Dollar Coin

In order to deal with the unnecessary debt ceiling, the government should indeed take advantage of the legal quirk allowing it to mint a platinum coin so that it can acquire newly minted money from the Fed to spend what Congress has already authorized. Since no further debt is created, the Fed’s money creation would effectively help most future taxpayers—that is, our children and grandchildren—instead of the wealthy interests who benefit from bailing out today’s financial industry and receiving the future interest payments on government debt. If the Fed refuses, the president should then simply mint smaller denomination platinum coins and pay its larger vendors directly with them.

Mint those coins, now.

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February 20th 2013

Carlos Blanco - Excellent article. A pleasure to read professor Van den Berg's clear explanation of a topic that creates a lot of confusion and is regularly exploited by republicans to scare voters. Obama should make it clear that if a deal is not reached before March 1st to avoid the automatic spending cuts, the coin will be minted.