Rutherfordian-Economics: Phony Debt Limit Discussions II-Monetizing the Debt

Hopefully, the phony debt limit discussions are behind us, at least for the moment. Along with that, people will start thinking about the basics of economic thought. Two of the more crazy ideas floated was to issue two 1 oz. $1 trillion coins or to sell an "exploding option". The two ideas have been suggested by Jack M. Balkin with relevant portion quoted below.

Sovereign governments such as the United States can print new money. However, there's a statutory limit to the amount of paper currency that can be in circulation at any one time.

Ironically, there's no similar limit on the amount of coinage. A little-known statute gives the secretary of the Treasury the authority to issue platinum coins in any denomination. So some commentators have suggested that the Treasury create two $1 trillion coins, deposit them in its account in the Federal Reserve and write checks on the proceeds.

The government can also raise money through sales: For example, it could sell the Federal Reserve an option to purchase government property for $2 trillion. The Fed would then credit the proceeds to the government's checking account. Once Congress lifts the debt ceiling, the president could buy back the option for a dollar, or the option could simply expire in 90 days. And there are probably other ways that the Fed could achieve a similar result, by analogy to its actions during the 2008 financial crisis, when it made huge loans and purchases to bail out the financial sector.

The "jumbo coin" and "exploding option" strategies work because modern central banks don't have to print bills or float debt to create new money; they just add money to their customers' checking accounts.

Agreed that I did suggest before that the Federal Government simply exchange one asset for cash from the Fed and then reverse the transaction after the so-called "crisis" is over. But the suggestions above is nothing more than creating money out of thin air with no exchange of assets. That is simply monetizing the debt, a procedure that all failed states use in the last ditch desperate measures (think Zimbabwe). The two suggestions above simply destroy the option or throw the coin away and do away with the reverse transaction.

Most disappointing about these suggestions is that educated, well-informed commentators are accepting this flimsy excuse for monetizing the debt. Cullen Roche accepts these ideas in his piece entitled Trillion Dollar Coin Idea Goes Mainstream. He has been one of the more reasonable writers that point out that quantitative easing is simply exchanging two assets on bank balance sheets. It simply swaps out T-bills for cash and eventually the Fed will unload the T-bills in the market or hold. It can only increase the money supply if it does not become excess reserves in the banking system and changes the behavior of market participants. Some behavior has changed, but not from the extra cash but expectations about future prices changed, although with commodity prices dropping again, it was short-lived.

Another person that should know better is Paul Krugman and at Lawyers, Coins, and Money he accepts the basic premise of Balkin's ideas with little critical thought. I maybe highly critical of Krugman, especially when he mixes politics and economic theories, but he should be able to see obvious signs of bad economic policies. His conclusions on the ideas are quoted below.

These things sound ridiculous — but so is the behavior of Congressional Republicans. So why not fight back using legal tricks?
And there is the constitutional option. Ronald Dworkin says that it works — or, at the very least, will put the issue into the courts for a while, which is better than destroying the economy next week.
Outrageous behavior demands extraordinary responses. Over to you, Mr. President.
Update: Stan Collender describes both these options and a possible deal in which Boehner passes a bill with Democrats but not the Tea Party as Lord Voldemort options — names not to be spoken, but always there.

So instead of "destroying the economy next week" let us really frag our economy for the long-run with hyperinflation. One bad by the Tea Party deserves an even greater foolish act by Democrats, got it.

Krugman also proves that he does not pay attention to the markets unless it fits his ideological bent at Where’s My Relief Rally? Since he posted that at 11 am, the market had gotten news at 10am that the ISM manufacturing report was below expectations and nearly slipping into contraction. His relief rally happened at 9:30 to 9:45am and the reality of low growth and the possible start of another recession became more important than what silly politicians are doing. Another way to say it is that the ISM Makes Debt Ceiling Rebound Short-Lived.

Krugman also shows signs of trying to argue both sides of the debate. He claims that there is some urgency in dealing with the debt crisis by stating that the economy will be destroyed next week and then claiming that Obama could actually say no to the deal worked out at If I Were In The House. That post implies that there really is no rush to get something passed now.

Hyperinflatistas Revisited
In my first post at Seeking Alpha, I considered Hyperinflationista Investment Strategies. There I discussed that it would be beneficial for the economy for people to actually invest/consume/save as if there was inflation or hyperinflation coming soon. In monetary terms it would increase the velocity of money and thus create more immediate aggregate demand, thus getting out of the liquidity trap. Dean Baker had a suggestion that a counterfeiter could spread the fake money around for a short time as this increases aggregate demand and most importantly on a short term basis. Even he admits that the phony money has to be eventually destroyed as this part explains.

But the interesting part of the counterfeiter story is that his $2tn of phony money will not create problems even in the long run, assuming that he is eventually shut down. Suppose that the counterfeiter's lavish spending gets the economy back towards full employment around 2012, at which point he gets nailed by the FBI who finally figure out how to recognise the dud notes.

At that point, the $2tn will be grabbed out of circulation and destroyed. Assuming that the economy is strong enough at this point to remain near full employment even as this counterfeit wealth disappears, then there would be no lasting damage from the episode. The fictional wealth had generated demand when the economy needed it, but then was pulled out of circulation at the point when it could have generated inflation and "competed away" goods and services from others.

This is much different than the proposed trillion dollar coins or the exploding options as ultimately the monetary base is reestablished and all illegal activities were reversed or mitigated.

What does this mean for investors?
If it becomes accepted into politics and the consequences of monetizing the debt is ignored by educated economists such as Krugman, then the inflationistas and hyperinflationistas will be right to compare the US to Zimbabwe. Once politicians drink from the endless well of infinite money growth, it is hard to turn back to reasonable policies.

Businesses and thus investors experience less and less reasonable investments as inflation heats up and interest rates rise. The net present value for longer term projects become negative and only projects that can start generating profits quickly can even be considered. Also risks and uncertainties multiple causing many projects to be cancelled as the risk premium rises.

Recently I was looking as some correlations between different measures of inflation and the S&P 500. Over the last 10 years there was no significance in regressing the S&P 500 although core inflation rates not seasonally adjusted tended to do better. On the sector level using iShares sector index funds (IYW IYM IYF IYH IYJ IYK IYE IDU IYC IYZ), I used ordinary least squares to test for any correlation. The best correlations although very weak was financials (IYF) with positive coefficient, and consumer services (IYC) with a negative coefficient. More significant was running the same sectors versus core CPI not seasonally adjusted. Industrial (IYJ) had the highest correlation but with a negative coefficient and second was consumer services (IYC) with a positive coefficient. This tells us that as producer prices rise it helps the financial sector and hurts consumer services sector. When core CPI rises it hurts the industrial sector but helps consumer services sector. It should be noted that I tested this over the past 10 years and it has been a long time since we even experienced double digit levels of inflation. So if we experience hyperinflation or even high levels of inflation the correlations may not hold.

So if something does pass the House, it will demand a constitutional balanced-budget amendment as the price of a second vote next year. I think we can safely say that the political process has failed. Now what?
Well, there do appear to be legal loopholes. Jack Balkin gives us the platinum coin option:
Sovereign governments such as the United States can print new money. However, there’s a statutory limit to the amount of paper currency that can be in circulation at any one time.
Ironically, there’s no similar limit on the amount of coinage. A little-known statute gives the secretary of the Treasury the authority to issue platinum coins in any denomination. So some commentators have suggested that the Treasury create two $1 trillion coins, deposit them in its account in the Federal Reserve and write checks on the proceeds.
And he also gives us the exploding-option option:
The government can also raise money through sales: For example, it could sell the Federal Reserve an option to purchase government property for $2 trillion. The Fed would then credit the proceeds to the government’s checking account. Once Congress lifts the debt ceiling, the president could buy back the option for a dollar, or the option could simply expire in 90 days.
These things sound ridiculous — but so is the behavior of Congressional Republicans. So why not fight back using legal tricks?
And there is the constitutional option. Ronald Dworkin says that it works — or, at the very least, will put the issue into the courts for a while, which is better than destroying the economy next week.
Outrageous behavior demands extraordinary responses. Over to you, Mr. President.
Update: Stan Collender describes both these options and a possible deal in which Boehner passes a bill with Democrats but not the Tea Party as Lord Voldemort options — names not to be spoken, but always there.