Can the Federal Reserve Ride in on a White Eraser?

More and more people are familiar with the Federal Reserve (Fed) and their use of Quantitative Easing (QE) to fund the US's debt addiction.  In simplest terms the Fed uses their 'magic pencil' to add new money to their balance sheet.  This newly-created-out-of-thin-air money is then used to purchase financial assets.  One important type of asset they purchase is US Treasury Bonds -- for which they recently have had a voracious appetite. 

When the US Treasury sells its bonds it is taking a loan from the purchaser.  By borrowing from the Fed the US increases its debt to acquire money that is used to fund ongoing budget deficits.

Two rounds of QE have now been completed and, as a result, the Fed owns approximately $1.7 Trillion of US Treasuries or around 12% of the US debt.  In fact, the amount held by the Fed far exceeds that held by China, Japan or any other foreign government.

A recent annoyance to the continued utilization of debt to fund our monetary policy arises because Article I Section 8 of the United States Constitution gives the Congress the sole power to borrow money on the credit of the United States.  Congress wields this power by establishing a debt-ceiling which limits the Treasury's borrowing power.  Presently, the US Treasury is up against that limit.  As a result, a multifaceted theatrical performance is being played out by our political leaders in hopes of getting the debt wagon back on track.  It appears, however, that there might not be enough room for political compromise to meet the looming date at which borrowing must cease and the piper is paid.

But what if there is more to the story of The Federal Reserve and The Magic Pen then has yet been told?  To date, we have only focused on the pencil's lead - the ability to create money from thin air.  The debt ceiling is only problematic because the Treasury can't sell more bonds to fund the budget deficit.  So, what if the Fed rides in on its white eraser to save the day?  Here's how it would work.  Remember they own $1.7T in US Treasuries.  What if they said 'hey, we bought those things with fake money anyway' and unilaterally decided to cancel those debts?   What if they simply take out their magic pencil, flip it over to the magic eraser end, wipe all or part of the $1.7T US obligation from their books and notify the US Treasury that they are canceling the debt?  

The Treasury will not have defaulted.  In fact, the US debt will be reduced by the amount the Fed forgives clearing room under the debt ceiling for additional lending.  No need for Congress to act.  No missed checks. 

The sole impact would be at the Federal Reserve; where it would unaffectedly erase the fake money that it added to its balance sheet.  Since it never really existed... who would miss it?

The primary argument against such a strategy is that it would signal to the financial markets that the Treasury, Fed and Congress are operating unconstrained by any normal rule of law.  The so-called "independence" of the Fed would be revealed as fraudulent.  Clearly, the markets would see it for what it is; an end run allowing the Treasury to bypass the debt ceiling limit and run open-loop; borrowing money the Fed will keep printing to pay bills the Congress will keep incurring as they overspend.  The US would then be seen as just another banana republic, able to do whatever it wanted in the fiscal monetary arena. This view would place us on the same paths taken by Weimar Germany, Zimbabwe and innumerable other countries who deliberately destroyed their currencies. 

To address that argument you have to answer three questions.  First, is there anyone left that still believes that the US does practice retrained monetary policy? Anyone observing US monetary policy for the last few decades is abundantly aware of the sixty odd times the debt ceiling has been raised and the expanding discrepancy between the currency in circulation and overall money supply (as shown in the figure below). They know how addicted to spending, indebted and over-leveraged we have become as a nation. We have long since abandoned normalcy. The emperor has no clothes.  Who is left that that believes he does?

The second question is, do they possess the hubris to do it? 

And finally, would someone speak up and stop this?  We'll see.

The author would like to acknowledge and thank Monty Pelerin for his helpful review and comments that directly impacted this article.

More and more people are familiar with the Federal Reserve (Fed) and their use of Quantitative Easing (QE) to fund the US's debt addiction.  In simplest terms the Fed uses their 'magic pencil' to add new money to their balance sheet.  This newly-created-out-of-thin-air money is then used to purchase financial assets.  One important type of asset they purchase is US Treasury Bonds -- for which they recently have had a voracious appetite. 

When the US Treasury sells its bonds it is taking a loan from the purchaser.  By borrowing from the Fed the US increases its debt to acquire money that is used to fund ongoing budget deficits.

Two rounds of QE have now been completed and, as a result, the Fed owns approximately $1.7 Trillion of US Treasuries or around 12% of the US debt.  In fact, the amount held by the Fed far exceeds that held by China, Japan or any other foreign government.

A recent annoyance to the continued utilization of debt to fund our monetary policy arises because Article I Section 8 of the United States Constitution gives the Congress the sole power to borrow money on the credit of the United States.  Congress wields this power by establishing a debt-ceiling which limits the Treasury's borrowing power.  Presently, the US Treasury is up against that limit.  As a result, a multifaceted theatrical performance is being played out by our political leaders in hopes of getting the debt wagon back on track.  It appears, however, that there might not be enough room for political compromise to meet the looming date at which borrowing must cease and the piper is paid.

But what if there is more to the story of The Federal Reserve and The Magic Pen then has yet been told?  To date, we have only focused on the pencil's lead - the ability to create money from thin air.  The debt ceiling is only problematic because the Treasury can't sell more bonds to fund the budget deficit.  So, what if the Fed rides in on its white eraser to save the day?  Here's how it would work.  Remember they own $1.7T in US Treasuries.  What if they said 'hey, we bought those things with fake money anyway' and unilaterally decided to cancel those debts?   What if they simply take out their magic pencil, flip it over to the magic eraser end, wipe all or part of the $1.7T US obligation from their books and notify the US Treasury that they are canceling the debt?  

The Treasury will not have defaulted.  In fact, the US debt will be reduced by the amount the Fed forgives clearing room under the debt ceiling for additional lending.  No need for Congress to act.  No missed checks. 

The sole impact would be at the Federal Reserve; where it would unaffectedly erase the fake money that it added to its balance sheet.  Since it never really existed... who would miss it?

The primary argument against such a strategy is that it would signal to the financial markets that the Treasury, Fed and Congress are operating unconstrained by any normal rule of law.  The so-called "independence" of the Fed would be revealed as fraudulent.  Clearly, the markets would see it for what it is; an end run allowing the Treasury to bypass the debt ceiling limit and run open-loop; borrowing money the Fed will keep printing to pay bills the Congress will keep incurring as they overspend.  The US would then be seen as just another banana republic, able to do whatever it wanted in the fiscal monetary arena. This view would place us on the same paths taken by Weimar Germany, Zimbabwe and innumerable other countries who deliberately destroyed their currencies. 

To address that argument you have to answer three questions.  First, is there anyone left that still believes that the US does practice retrained monetary policy? Anyone observing US monetary policy for the last few decades is abundantly aware of the sixty odd times the debt ceiling has been raised and the expanding discrepancy between the currency in circulation and overall money supply (as shown in the figure below). They know how addicted to spending, indebted and over-leveraged we have become as a nation. We have long since abandoned normalcy. The emperor has no clothes.  Who is left that that believes he does?

The second question is, do they possess the hubris to do it? 

And finally, would someone speak up and stop this?  We'll see.

The author would like to acknowledge and thank Monty Pelerin for his helpful review and comments that directly impacted this article.

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