A deal was reached over the weekend by congressional leaders and the President to resolve the debt-ceiling impasse. By that point, it was clear that the possible way out described by John Carney in a blog post to which we linked on Thursday would not be feasible. Nonetheless, the Fed’s ability to supply cash as needed if the deadline were missed had been made clear in official statements reported by the New York Times in Sunday’s early print edition. To wit, in response to concerns expressed by top banking executives,

“Mr. Geithner made it clear that the Treasury and the Federal Reserve had taken precautions so that payments for food stamps, military wages, and other federal obligations would not bounce, according to people involved in the call.”

An article posted to the Times website Saturday had phrased this point somewhat differently:

“Mr. Geithner assured [JPMorgan Chase CEO Jamie Dimon] that the Treasury and Federal Reserve had taken steps to keep the payment system functioning smoothly, according to individuals briefed on the call.”

The phrase “keep the payment system functioning smoothly” is a euphemism known by Fed observers to entail in practice the types of functions described  in the above quote of the print edition.

Obviously however, this use of overdrafts could not be continued very long, owing to the will of the negotiators and probably the relevant laws. These laws are intended to keep the Federal Reserve largely independent from the federal government.   Hence, while the Fed honors checks written by the Treasury Department and presented to it by banks, the use of this privilege is extremely limited in the U.S. system, compared to “overdraft systems” of the type I described in this earlier post.

On the other hand, if the somewhat artificial distinction between the central bank and the central government were to be eliminated in the United States, the federal government would gain access to the printing press, enabling it hypothetically to back a virtually unlimited amount of outlays. Of course, this process would not create new “debt,” but rather new currency and bank reserves. Of course, the Fed itself can currently use its “printing press,” mostly to stabilize the banking system, a role that led to a massive expansion of bank reserves during the financial crisis of 2007–08.

In current mainstream macroeconomic thought, which is carrying the day in most of the developed world now, a system in which the government has control of the printing press is thought to court intolerable levels of inflation. However, in an economy growing as slowly as this one, it is extremely doubtful that excessive inflation would necessarily follow if the impasse were to be resolved by creating new currency and bank reserves, rather than by selling bonds, increasing taxes, or cutting spending. Yet given the legal independence of the Fed, the latter two options were the only ones open to the negotiators last weekend. Moreover, new taxes were unacceptable to many, if not most, in Congress.  Hence, it now appears that the government may be about to make potentially devastating new cuts to key federal programs.

(Click figure to enlarge.)

Could the government loan the money to itself? The federal government is expected reach its debt limit of $14.29 trillion early next month. Normally, the government more or less indirectly sells a large amount of Treasury securities to the Fed, which is technically a private entity, separate from the familiar government run by the President, Congress, and the Supreme Court. This amount has been increasing rapidly, as shown by the red line in the figure above. As the figure suggests, quantitative easing II, or QEII, which officially ended last month, represents only the most recent version of this sort of open-market policy initiative, though it was highly unusual in that it involved very large purchases of Treasury bonds. Hence, even when the government finds that it has to borrow money to pay for its expenditures, it need not borrow from domestic or foreign private investors, or even foreign central banks or the International Monetary Fund (IMF). Instead, it can essentially turn to itself, borrowing from what is close to a government agency, charged with acting in the public interest. Nonetheless, unfortunately, official Treasury Department bond auctions will presumably cease if and when the federal borrowing limit is reached, rendering Fed purchases largely irrelevant to the resolution of Washington’s debt-limit predicament.

Hence, the question arises: if the federal government doesn’t always borrow from the public when it sells bonds, but instead often relies on the Fed, why not dispense with Treasury bond sales altogether and have the Fed simply loan or even transfer funds directly to the federal government whenever tax revenues fall short of expenditures? It would obviously not be simple or easy to switch to such a monetary system, but at least until fairly recent times, most developed countries outside the English-speaking world found it best to provide liquidity for government activities in this way, avoiding the use of open-market operations and making their central banks more literally into instruments of the national governments involved. In such banking-oriented systems, private companies, too, tend to rely heavily on banks rather than financial markets when they need to obtain funds to build new plants, etc. Interest rates are mostly set directly by the banking system rather than in markets. Such financial systems have both advantages and disadvantages, relative to systems like the American one that rely far more heavily on securities and derivatives markets. In many ways, though, the two types of central bank are fundamentally the same, particularly in the way they are relied upon to help pay for government operations.

The issue remains, though, is there anything to be gained by having specific numerical limits on government debt such as the ones imposed by the U.S. Congress? The answer is “no.” Keeping the current limit would only result in a self-imposed disaster.

Update, July 21: Fellow Levy Institute scholar Randy Wray expresses some of the opinions and ideas set forth above in a great blog post that coincidentally appeared on the same day as the one above.  G.H.

Update, July 26: James Surowiecki argues to good effect that debt ceilings should be eliminated in a new article in the New Yorker. -G.H.

Paul Krugman slugs it out with our colleague Jamie Galbraith and many other “modern monetary theory” partisans at Krugman’s New York Times blog website. Jamie’s most recent retort is at the top of this page of the blog site. Many of the points raised in the discussion there are central to our work here at the Levy Institute and to the views of Galbraith and others in our macro research group.

Update: More links to the ongoing Krugman-MMT debate can be found here.  -G.H., March 31.

Update, August 11: Krugman on MMT again, this time drawing lessons from French fiscal policy between World Wars I and II.