Preventing the Next Crisis: What We Must Do to Maintain the Public’s Confidence in the Financial System
Last month, as the debt-limit crisis was heating up, I wrote two columns for Justia’s Verdict (here and here) arguing that President Obama had the responsibility to ignore the debt-limit law in order to execute his duties under the spending and taxing laws passed by the current Congress. I pointed out (in the earlier of those two columns) that it was important for the President to do so during this crisis, not only to avoid the disastrous effects of reaching the debt limit on August 2, but also to avoid a repeat of this political tragicomedy in the future.
Last week’s deal to increase the debt limit at least temporarily steered us away from the abyss, until just after the 2012 elections. Unfortunately, however, the Republicans have wasted little time in announcing that they have every intention of continuing to use the debt limit as a political weapon. Indeed, as soon as the deal was finalized, the Republicans’ leader in the Senate, Mitch McConnell, said: “Whoever the new president is, is probably going to be asking us to raise the debt ceiling again. Then we will go through the process again.” This was disappointing, but hardly surprising.
The Best Solution Now: Don’t Raise the Debt Limit; Eliminate It
The most sensible solution to this threat is not to raise the debt limit, but to eliminate it entirely. There is no reason for a debt-limit statute even to exist, after all, because a Congress that puts a high priority on the debt’s never exceeding any particular level can choose to always pass a budget that prevents that from happening.
Thus, the only thing the debt ceiling does, as a non-political matter, is to create an after-the-fact quandary for whoever is the current president, who must, thanks to the debt ceiling, decide how to enforce contradictory laws.
Late last week, the editors of The New York Times sensibly added their collective voice to the call to eliminate the debt ceiling entirely. In particular, they suggested that President Obama should instruct his attorneys to build a case under the Fourteenth Amendment to the Constitution, preparing to defend as necessary a future Presidential directive to issue debt in excess of the statutory limit. The purpose of building such a case, of course, would be to avoid a repeat of the kind of political hostage-taking that we have so recently witnessed.
There might be additional options for the President to explore, however. Professor Jack Balkin of Yale Law School, among others, has recently described two options that appear to be fully legal, and that could create an escape hatch for a President who is faced with a future debt-limit crisis.
While these options are worth considering, however, they could also inadvertently threaten the viability of this country’s financial system. If handled poorly, they could create problems far greater than a debt default, possibly including the breakdown of our financial system. If we are going to consider those options, therefore, we need to make sure that the public will accept their legitimacy.
Sovereign Governments and the Creation of Money
One of the most basic powers of a national government is the power to create money. When a new country is formed, one of the government’s first sovereign acts is to issue and regulate a currency. When a national government is able to issue debt denominated in its own currency, therefore, it is promising to repay its creditors with a means of payment that is completely within its control. Here in the United States, for example, the federal government is the sole source of our dollars, and our federal debt must be repaid in those dollars.
Clearly, no other borrower is in such an advantageous position. National governments, however, know that they cannot simply create as much money as they like, because, at some point, lenders will understand that the money to be repaid will have lost all value. Credit-worthy governments must therefore limit their borrowing to levels that borrowers would view as sufficiently prudent.
Fortunately, for all of the talk about the dire fiscal situation facing this country, we are nowhere near the point where borrowers would reasonably be worried about being repaid in devalued dollars. To the contrary, far from putting us in danger of creating ruinous inflation, our current policies have us poised on the edge of another recession—if, indeed, we are not already there.
Would it not make sense, under these circumstances, for the federal government to avoid the statutory limit on the issuance of government debt by simply issuing more money? In a sense, this would simply skip a step, allowing the government to spend money that the government has created, without going through the process of borrowing that money from private lenders and then repaying them with new money.
The problem with this solution is that the debt-limit statute itself prevents the federal government from using its established procedures to create money to cover the difference between spending and taxes. To understand why this is so, it is first necessary to review how the government generally creates new money.
The Federal Reserve, Treasury Bonds, and New Money
Politicians often talk misleadingly about “turning on the printing presses” to describe how money is created. In fact, very little of what counts as “money” in our system exists in the form of currency. People make most of their purchases with something other than dollar bills: They use checks, credit cards, on-line transfers, and so on. Monetary economists have long debated what should and should not be counted as money, but even if one were to use the most limited definition of what counts as money, the amount of money in existence would be many times larger than the value of the currency in circulation.
The Federal Reserve (commonly called the Fed), which is the central bank of the United States, is authorized by law to regulate the amount of money in existence. It has no power to print money, but it creates new money all the time. Its method for doing so is actually rather indirect, but it has worked perfectly for decades.
When the Fed wants to inject more money into the economy, it buys Treasury bonds in the financial markets from people who want to sell those bonds. The transaction involves having the parties that want to sell their Treasury bonds accept as payment deposits from the Fed into their bank accounts.
The Fed thus takes possession of Treasury bonds by putting “new money” into private parties’ bank accounts. The new money is non-physical, amounting to a statement from the Fed to the parties’ bankers that, should anyone challenge the validity of the deposits, the Fed will stand behind them. The people who sold their bonds thus have new money that they can spend as they wish.
Although this method works very well, and is generally unquestioned within our financial system as the correct way for the government to control the supply of money, it involves having the Fed take possession of trillions of dollars of Treasury bonds. While the Treasury bonds in the Fed’s possession are, in fact, no longer in the public domain, they are still considered to be “outstanding,” because they have not yet been paid in full by the Treasury.
The debt-limit statute, however, places a ceiling on the total value of the Treasury bonds that can be outstanding. This means that the Fed cannot use its normal procedures to create “new money” to help avoid a debt-limit crisis, because doing so would not reduce the amount of Treasury bonds outstanding, which would mean that the Treasury could not borrow more money to cover its expenses.
The Fed, therefore, cannot create money in the usual way to assist the Treasury, when there are not enough funds available to pay the government’s bills. The question, however, is whether there are unusual—but legal—ways for the Fed could to become involved in a workaround, in a future situation in which we reach the debt limit.
Alternative Financial Solutions to the Debt Problem
Two novel ideas have recently been floated to deal with future debt-limit crises: issuing coins, and issuing financial options. (Professor Balkin has also described a plan to issue credit-default swap, but he explicitly calls it “not a serious proposal.” The idea here is to start thinking creatively about ways to prevent a repeat of the hostage-taking that we experienced earlier this year.)
The advantage of these options, in contrast to ignoring the debt ceiling or prioritizing payments on government obligations, is that none appear to involve violating the law. Therefore, it might not be true that there is an inescapable bind when the debt-limit, taxing, and spending laws are in conflict. Instead, there might actually be an escape hatch when such a conflict occurs.
The First Idea: The Big Coin Strategy
The first idea is sometimes called the Big Coin strategy. It turns out that there is a statute limiting the amount of currency in circulation, but there is no statute limiting the amount of coinage that the Treasury can authorize. Clever legal minds thus wonder: Why not allow the Treasury to issue as many coins as it needs to cover its bills, beyond the debt limit?
The intuitive answer is that it would be prohibitively expensive to create enough coins to meet our needs. This point, however, misunderstands the nature of coinage. Just as currency is worth more than the paper on which it is printed, so too are coins worth more than the value of the metals used to mint them. It would be possible, therefore, for the Treasury to issue even a single coin in a designated amount sufficiently large to cover the government’s needs. One two-trillion dollar coin, for example, could have covered the possible shortfall for the remainder of 2011.
The “big” part of Big Coin, moreover, describes the dollar value of the coin, not its physical size. Just as dimes are worth more than nickels and pennies, there is no necessary correlation between size and value.
If the Treasury were to deposit such a coin in its account with the Fed (which also acts as the Treasury’s banker), the Treasury could then issue its usual run of checks to pensioners, federal contractors, disabled veterans, and so on. Rather than borrowing money from the public, and ultimately having the Fed pay the public back with new money, the Treasury itself would simply create the new money.
The Second Idea: The Exploding Option Strategy
The second idea, sometimes called the Exploding Option strategy, involves having the Treasury sell the Fed a financial option to purchase government property, with the Fed paying (in the current example) two trillion dollars for the right to foreclose on something that the Treasury owns.
The option could have an expiration date, or it could be repurchased later for a dollar by the Treasury. The idea would be for the Fed to enter into the transaction with no intention of ever foreclosing on the property at issue. Thus, the Fed would essentially be simply transferring money to the Treasury in a form that is not counted as outstanding against the statutory debt limit.
Both of these options appear to be legal, although there is at least some reason to worry that they flout the spirit of the law. In the face of a crisis, however, such niceties as the law’s spirit become more elastic, if the law’s letter, at least, can be honored. If the choice is between issuing trillion-dollar coins and storing them at the Fed, or failing to meet our obligations on schedule, the choice would seem clear.
The real problem, though, lies not in the legality of these options, but in their possible effect on the public’s confidence in the financial system.
The Fragile Nature of Public Confidence in Money
There is an old Monty Python sketch in which a mock news report describes a new method of building public housing projects. The British government, short of money, decides to hire a hypnotist to convince people that a high-rise block of apartments exists. So long as everyone believes that the apartments exist, there is no problem. In an interview, however, a man in one of the apartments starts to doubt that the apartment exists, and the building starts to shake and topple. He then shakes off his doubts and decides that there is nothing to worry about, and all is well again.
The nature of modern money is surprisingly like the situation in that sketch, but with a twist. As long as people believe in the value of money, money has value. The psychology is even more abstract than in the Python example, however, because people need to be concerned not about what they believe, but about what they think other people believe. That is, even if a person knows full well that dollars have no intrinsic value and are created as mere accounting entries on the Fed’s balance sheet, she still has no reason to worry, so long as she thinks that other people will continue to accept money as a means by which she can pay her bills. (This is true of gold and other commodity-based moneys as well, by the way.)
There have been times when the public’s confidence in the validity of dollars has been shaken. Two years ago, for example, there was a surprising spate of public debate about the Fed’s policies to bail out the financial system in the face of a possible global economic depression. Even some financial writers began to talk darkly about the Fed creating money “out of thin air.”
However, as I pointed out at the time, money is always created out of thin air, because money has no intrinsic value. Even so, a great deal of public discussion at the time involved claims that the Fed was somehow engaged in a categorical error, and creating money illegitimately, when, in fact, it was doing nothing of the kind.
If the public (even the informed public) can so badly misunderstand the plain-vanilla methods of controlling the money supply, then one cannot help but worry about how people would respond to the Big Coin or Exploding Option strategies. Both of them, by design, are ingenious efforts to allow the Treasury and Fed to do what they could not do under the usual rules. Both, therefore, run the risk of seeming completely illegitimate to the public at large.
The consequences of such a loss of public confidence could be dire indeed. Even if financial traders understand that there is nothing inappropriate going on, they must react not to what they know but to what they think other people are thinking. If the public begins to doubt the legitimacy of the government’s financial policies, traders would have to respond by shunning U.S. financial securities, including the Treasury bonds that make up the national debt.
The Irony Of the Big Coin and Exploding Option Strategies
The irony, therefore, is that the strategies that have been designed to work around the crisis without invoking the Fourteenth Amendment could run into that very amendment’s prohibition of engaging in any actions that can bring the validity of the public debt into question. We would no longer, moreover, be quibbling over whether there is a difference between a government’s “debt” and its “obligations” for Fourteenth Amendment purposes, because the strategies could directly challenge the validity of the government’s debt securities, which are denominated in dollars.
Admittedly, this is a worst-case scenario. It is possible that cooler heads could prevail, with respected voices calming public fears and letting everyone go back to believing in the validity of their dollars. In the midst of such a crisis, however, it is difficult to know to whom the respected voices would belong. The danger in taking novel actions is that no one can say, “Don’t worry, we’ve always done it this way.” Money is—and absolutely must be—an abstract and notional social convention. Thus, there is a very real possibility that the financial house of cards could collapse in the face of too much cleverness.
Fortunately, we now have some time to figure these things out. If there are ways to create a legal strategy that prevents the use of the debt-limit statute for future political leverage, then we should surely explore them. Because we are dealing with the most fundamental aspects of a modern financial economy, however, we must tread very carefully. A constitutional crisis over a President’s decision to ignore the debt limit would be bad. But an economic crisis over the public’s loss of confidence in the nation’s currency would be far, far worse.