Denial, Default, or Treasury Currency

 

Takeaway

  • Monetary finance is the practice of using a government's debt to fund its own bailout, as Spain recently attempted
  • During the Civil War, the U.S. Treasury created currency in the form of U.S. Notes to pay the government’s bills
  • The U.S. could attempt this again, but it carries inflation risks

Spain's financial vulnerability has been in the spotlight recently. The trickle-down from a single bank's insolvency gives us a glimpse of how country funding shortfalls are likely to be handled in the coming decades.

The Spanish bank in question, Bankia, was short $23 billion of regulatory capital — small change compared to Spain's existing debt and additional debt to make good on future baby boomer entitlements over the next four decades.

To plug the hole in Bankia's capital shortfall, Spain offered a promissory note to Bankia, which to the bank is an asset. To pay for this asset, Bankia offered equity shares of Bankia in favor of the Spanish government. With ownership of the bank shifting to the government, bank “nationalization” thus occurred.

The financial trickery became more interesting when Bankia attempted to turn the Spanish government IOU into ECB currency by borrowing from the central bank and using the Spanish government note as collateral. Perhaps this plan could have worked with a cooperative ECB, which might have gone along with the scheme, as it is constantly lowering collateral standards in order to spread financial resources over Europe’s government and bank needs. 

However, the ECB demurred in outrage with Spain’s scheme to tape an ECB currency loan on grounds that the collateral was not suitable. The issue was not so much the collateral but the fact that the transaction would have set a precedent for how the individual governments of the Eurozone could get control of the Euro printing press for their own bailout needs.

It was a nice try, if you ask me, to put Spain in control of Euro monetary policy to fund its own bailouts — a practice called "monetary finance," which the ECB insists was not part of its obligations to member nations.

The scheme did indeed recapitalize the bank in question, allowing Spain to honor its financial guarantee to an insolvent bank, but it just couldn't take it the next step to turn the country’s IOUs into Euro currency.

However, in the U.S., using fiscal schemes to turn country IOUs into currency to pay the government’s bills is a far more straightforward operation with no "independent" central bank to say no.  Indeed, during the Civil War, when the government was faced with wartime expenditures well beyond its limited taxing authority and a limited market for its debt, the National Banking Act of l862 empowered the U.S. Treasury (not a central bank) to issue "money" to pay the government's bills. Payment to the soldiers was the most pressing expense, with the money being designated United States Notes.

Since it was unclear whether the Treasury possessed the Constitutional authority to create money to pay its bills, there was a workaround less complicated than Spain’s attempt to turn country debt into money.

The U.S. Treasury issued zero-coupon, infinite-maturity debt stylized as United States Notes, which were bearer notes denominated in dollars and, most importantly, had the government-bestowed status of "legal tender." This meant that these paper IOUs satisfied all private and public contracts, thus turning debt into currency.

The designation of legal tender can be seen in the fine print in the below image of a U.S. Note. To verify the point, merely take a look at the Federal Reserve Notes in your wallet and read the identical fine print regarding legal tender status.

The modern version of this U. S. Treasury debt stylized as currency looks familiar. It still exists (and circulates) 150 years later, though most of the Notes are locked up in numismatic collections.  The Treasury currency is similar in appearance to Fed currency designated as Federal Reserve Notes except the Treasury currency is designated as United States Notes across the top of the bill. Both are printed by the Bureau of Engraving and Printing which resides in the Treasury Department.

Now sit back and think of the possibilities presented by the Treasury’s direct money option to pay the government’s bills. This would allow the U.S. to cover the next four decades of baby boomer entitlements (which are well beyond the ability to finance in conventional style) and would also make the existing government debt load significantly more manageable.

It would free the Federal Reserve from the pressure to monetize government debt in round after round of QEs over the next four decades. The Fed could confine itself to matters associated with growth and employment and would be free of the stigma that it created the inflation that would no doubt occur.

In fact, in monetary finance, purchases with Treasury money would be in goods markets rather than financial markets as the Fed conducts its operations. That is, the inflation would be goods inflation, not financial price inflation as we presently have with Fed QEs, which allows hardly any spillover to goods markets.

How difficult would this be to carry out? Well, it would take getting a one-sentence bill through Congress and a Presidential signature to amend the National Banking Act to raise the Civil War maximum issuance of U.S. Notes from $300 million to some number in the trillions. Indeed, it could be treated as correcting a spelling error from millions to trillions, skipping billions altogether. It might even fly under the radar screen and only be a subject of interest to monetary wonks who pay attention to these things (such as the author) and presumably Representative Ron Paul. A final detail that needs to be addressed in the bill is the time limit for new issuance of the currency.

What a game changer that would be, and not just to the prospects of avoiding an actual U.S. debt default down the road — which would happen if the baby boomer bills were to be paid conventionally with debt.  It would also eliminate the entangled political web of attempting to decide which promised (and in some cases paid–for) entitlements to cut and which taxes to increase. It would be more consistent with a growing economy, though the cost would be the damage done by 40 persistent years of inflation. Entitlements would be paid but watered down in real terms without further debate. We could change our focus of attention to growth instead of income redistribution.

This is certainly not a first best policy, and it is offered as a forecast of what will be the way out of an unmanageable political and debt strangulation. It does beat frozen government, an appalling deflationary economic contraction, and an almost certain government default down the road unless the same debt is monetized by a compromised Fed.

The major question would be the inflation rate and the damages and redistributions from it. Certainly it would be beneficial to debtors at the expense of creditors.

From the stroke of the pen signing into law the enabling legislation of raising the authorized issuance, fixed income securities would dive in value, gold would salute and real return instruments would soar. Parenthetically, it would cure the housing price decline and consumer wealth decline almost instantaneously and cause the economy, though inflationary, to function better than it presently does.

While Spain attempted monetary finance this month, the U.S. could pull it off without a central bank veto. While this would seriously undermine the currency value, it is better than destroying all faith in the government and its institutions in these days of government denial and paralysis.

This is a pragmatic look at one of the few options remaining in this world of detestable Hobson choices facing the electorate and its government. It could be shortly or years down the road, but all it takes is a Solomon P. Chase to focus on the art of the possible, perhaps known henceforth as the sesquicentennial solution to deal with the baby boomer entitlements. If there is no Chase-type visionary, mere pragmatism will get it done. It’s the only option left short of default on the entitlements or default on the debt to pay the entitlements.

This article originally appeared on Dr. Spellman’s blog, The Spellman Report.

Disclaimer

The views expressed are those of the author and not necessarily The University of Texas at Austin.

About The Author

Lew Spellman

Professor, Department of Finance, McCombs School of Business, The University of Texas at Austin

Lewis Spellman received his BBA and MBA from the University of Michigan and his MA and Ph.D. from Stanford University. His research interests include...

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