Ron Paul, Mankiw, and the Government Debt

Ron Paul recently suggested a solution to the debt-ceiling problem

"We owe, like, $1.6 trillion because the Federal Reserve bought that debt, so we have to work hard to pay the interest to the Federal Reserve," Paul said. "We don't, I mean, they're nobody; why do we have to pay them off?

Paul's logic is the following. The debt ceiling applies to all Treasury debt outstanding, but currently $1.6 trillion of the total $14.5 trillion in Treasury debt is held by the Fed. We all know that the Fed is a large leech sucking our blood, so why not call a temporary truce in the debt-ceiling/budget war by simply defaulting on the $1.6 trillion in debt held by the Fed?

Dean Baker likes the idea. He also seems to be thinking like the Fed Chairman of 1937 in that he thinks an increase in reserve requirements would be a great idea. This guy doesn't like Paul's idea as he thinks it would cause a hyperinflation.

Now, along comes Mankiw to the rescue. He poses the problem as an exam question, then gives you the solution, in a few lines. What Ron Paul is suggesting is only an "accounting gimmick," and it is actually irrelevant.

Now, to work through this, consider two alternative scenarios. First, suppose that, in the absence of Paul-default, the Fed holds the Treasury debt it has acquired until maturity. In this case, clearly Paul-default cannot make any difference. Without Paul-default, the Treasury makes the payments on the Fed's Treasury holdings to the Fed, and the Fed sends those payments back to the Treasury. With Paul-default, the net flow between the Fed and the Treasury is the same: zero.

The second scenario is the interesting one. Suppose that, in the absence of Paul-default, the Fed were to sell the Treasury debt before it matures, in a reverse-QE2 program. Under Paul-default, reverse-QE2 is not possible, as the Treasury has defaulted on the Fed's debt and therefore no one else wants it. According to Ben Bernanke and, more recently, Jim Bullard, QE2 works (worked), i.e. purchases of long-maturity Treasury securities by the Fed moves asset prices and increases the inflation rate. If QE2 works, then reverse-QE2 works too. Thus Paul-default, by foreclosing reverse-QE2, matters.

Not so fast, though. Actually the working hypothesis should be that QE2 was irrelevant (see this too), no matter what these people say. In that case, it's not going to matter whether the Fed holds its Treasury portfolio until maturity, or not. Mankiw is right, but the exam question is a little harder than he thought.