In the many years I’ve spent scrutinizing monetary policy, I had never devoted more than a thought to coins. In the scheme of all things monetary, they seemed, well, pocket change.
Needless to say, the prospect of the Treasury issuing a $1 trillion platinum coin to circumvent the debt ceiling changes that. I won’t repeat the details; you can get up to speed by reading Matthew O’Brien of The Atlantic here and my colleague here. If nothing else, unpicking the consequences is a fun exercise. I’ve concluded the economics are more complicated and more benign than appreciated, but the political consequences are graver.
(This is going to get rather abstruse, so bear with me.) Let’s start with the role of coins in the money supply. Long before there was a Federal Reserve, the United States government minted coins, often of silver and gold (specie). Private banks used these coins to back their own, private bank notes. The Fed took over issuance of bank notes in 1913, but coins remain the purview of the Treasury. Since bank notes are a liability of the Fed, they are, like reserves, part of the monetary base, the building block of the broader money supply. Coins, however, are a liability of the Treasury. In fact, in economic terms, coins are analogous to perpetual, zero coupon Treasury bonds. The Treasury can issue coins to the public and use the proceeds to finance the budget, just as if it issued bonds.
Ordinarily, the Fed buys coins from the Treasury in response to demand from banks and pays for them by printing money which goes into Treasury’s account at the Fed. Sound familiar? It is, in economic terms, exactly the same as quantitative easing, when the Fed buys government bonds and pays for them with newly created money, deposited in banks’ reserve accounts.
There are some differences, however. While the Fed’s balance sheet expands when it buys a coin, the monetary base- the building block of the money supply – does not. That’s because, coins, unlike bank notes, are an asset to the Fed, not a liability. You can see this by examining the Fed’s balance sheet here. The Fed would pay for the $1 trillion platinum coin by creating an equivalent deposit in the Treasury’s account. Treasury deposits aren’t part of the monetary base, either. As the Treasury spent that money, however, it would shift from the Treasury’s accounts to the reserve accounts of commercial banks. For example, suppose Treasury sends a $1000 refund check to a taxpayer, who deposits it in his account at Citibank. The Fed moves $1,000 from the Treasury’s account to Citibank’s reserve account. The Fed's liabilities remain the same, but the monetary base expands, by as much as $1 trillion, eventually.
Is that inflationary? Paul Krugman says not now, but maybe later:
Printing money isn’t at all inflationary under current conditions — that is, with the economy depressed and interest rates up against the zero lower bound. But eventually these conditions will end. At that point, to prevent a sharp rise in inflation the Fed will want to pull back much of the monetary base it created in response to the crisis, which means selling off the Federal debt it bought.
I disagree. The Fed does not have to sell its bonds, or the $1 trillion coin, to control inflation (though it may do so anyway). It only needs to retain control of interest rates, and that does not depend on the size of its balance sheet.
This, by the way, is at odds with the textbook IS-LM model in which the Fed sets a fixed money supply (represented by the upward sloping LM curve)
But in the real world, the Fed sets a fixed interest rate and lets the money supply adjust. Back in 2000 David Romer proposed modifying the IS-LM model to reflect this reality. In his IS-MP model, the upward sloping LM curve is replaced by a horizontal MP curve.
This essentially explains why no major central bank targets the money supply. The money supply does matter, but for narrow, technical reasons. The Fed controls the short-term interest rates by adjusting the supply of reserve balances between banks. Ordinarily, creating trillions of dollars of reserves through QE (or buying a $1 trillion coin) would overwhelm any conceivable demand by banks for interbank funds, forcing the Fed funds rate down to zero. This would rob the Fed of control of interest rates and thus inflation. In this circumstance, Mr Krugman would be right: the Fed would have to sell vast amounts of bonds and other assets, and the $1 trillion platinum coin, to drain those reserves and regain control of interest rates.
But in 2008, Congress gave the Fed authority to pay interest on reserves. Because banks should not lend reserves to each other for less than they can get from the Fed, this restores the Fed’s control over interest rates regardless of the size of its balance sheet, and thus over inflation.
Fed staff have laboured for years on the mechanics of this exit process; they can't be sure how it will transpire, since the Fed has never had to raise interest rates with so much excess reserves in the system. But the experience of other central banks, in particular the Reserve Bank of New Zealand, “suggests that tightening by increasing the interest rate paid on central bank balances can help reduce or eliminate the need to drain balances,” according to a 2010 study by three Fed economists.
What this means is that while the platinum coin option expands the Fed’s balance sheet and, ultimately, the monetary base, it has no implications for inflation, even if the Treasury never buys back the coin.
But while the economic consequences for the Fed are benign, the political consequences are not. As I noted earlier, the Fed buys coins in response to demand from commercial banks (the process is explained here). Banks won’t want a $1 trillion platinum coin, so the Fed will only buy the coin if Treasury forces it to. The Treasury, in “depositing” its coin at the Fed, is in reality ordering the Fed to print money. And if Treasury doesn't take the coin back, the money stays printed.
The economics may be the same as QE; as Mr Krugman notes, coins, like bonds, are liabilities of the central government. But the politics are utterly different. We have a central bank to separate fiscal from monetary policy. The Fed implements QE when it has decided that’s the best way to carry out its monetary policy objectives. Buying a coin solely to finance the deficit is monetizing the debt, precisely the sort of thing central bank independence was meant to prevent. How could any Federal Reserve chairman justify cooperating in such a scheme, in particular since the Fed would be taking the White House’s side in a fight with Congress over a matter of dubious legality?
Yes, the Fed has sacrificed its independence for the sake of the national interest before, such as maintaining a ceiling on Treasury yields between 1942 and 1951; but that was (initially) in wartime, and it eventually led to inflation. Would avoiding the debt ceiling be important enough to compromise the Fed's independence? Perhaps not in this one case; but it would set a precedent future presidents will happily exploit and feed the perception that America’s economic institutions are in terminal decline. America has had debt ceiling crises before (in 1957, 1985, 1996 and 2011) and survived; are the unknown risks of the platinum coin option obviously preferable to the known risks of hitting the debt ceiling?
There is a way around this problem that preserves the Fed’s independence. That would be for the Treasury to issue the coin to the public, instead of the Fed, thereby leaving the Fed’s balance sheet, and its control of monetary policy, alone. Of course, no one would want a $1 trillion coin. But Gary Gorton, an economist at Yale University, suggests there might be demand for a bunch of $50 million coins. He notes the financial system still craves safe, liquid assets. Corporations in particular are desperate for a safe place to park cash now that unlimited federal deposit insurance has expired. Including fees, many bank accounts now sport negative yields, as at times do Treasury bills. Money market mutual funds may float their asset values. Platinum coins would represent a risk-free, liquid way to store cash with no risk of negative yields.
Of course, if the CFO lost one down a sewer grate, it would be a disaster. So instead, the Fed could simply keep the coins in a vault with their owners’ names affixed. When one owner wants to settle payments with another, the Fed could simply switch labels. In the meantime, Treasury gets the equivalent of an interest-free loan from the public and a reprieve from the debt ceiling. Not quite a free lunch, but close enough.