Tuesday, July 26, 2011
A close analysis of Ron Paul's Bloomberg Op-Ed
In order to see into the mind of the men who are behind the brinksmanship over the debt ceiling it is instructive to read the editorial that Ron Paul wrote to on Bloomberg on Thursday. Ron Paul is a Republican and a libertarian who is a presidential candidate so his views are important. Among his more controversial views are the ideas that both heroin and prostitution should be legal. Whether you agree with these views or not I think they are consistent with his views of the effects of the consequences of a breach of the debt ceiling: that is to say they begin with a deceptively simple premise but struggle under close analysis.
Ron Paul is one of the leading conservatives pressing for a voluntary default through a Congressional refusal to rasie the statutory debt limit. His overall view is that such a default would be painful but not catastrophic and would, in the long term, be healthy because by withdrawing access to capital markets the government would be forced to live within its means. He would prefer this to happen sooner rather than later. It seems to me from his editorial that his views are based on a false analogy, a clear lack of understanding of the mechanics of a fiat monetary system, the role of the Central Bank, and the degree to which a default would resolve our problems by becoming some kind of deus ex machina which would instill the discipline that he and his colleagues, and ultimately we the voters, have so far been unable to muster.
Paul begins his editorial by claiming that default by the US government is a common occurrence and each time it has not been followed by a major calamity. The three examples he mentions are as follows: first when Roosevelt revalued the dollar against gold and forbade transactions in gold in 1934. The second is when congress stopped silver redemption of the dollar in 1968, and the last was the “Nixon Shock” when Nixon halted gold the convertibility of dollars into gold at the rate fixed via the Bretton Woods Accords. As should be obvious to anyone with an economics background, none of these events constituted a formal default. They were all currency devaluations. They were steps on the road from a monetary system tied to gold to a “fiat” system, one in which the values of currencies were determined by the “faith” of markets.
From the post Civil War resumption of payments in gold in 1871 until the end of the Bretton Woods international monetary system in 1972 the US dollar was convertible into gold or silver at a fixed ratio though that ratio was periodically subject to change. In the early 1930s after the stock market crash precipitated the systemic collapse of the US banking system America entered a deflationary spiral. Because the dollar was pegged to gold the Federal Reserve lacked the tools that Ben Bernanke has used to prevent a similar deflationary spiral in the aftermath of the real-estate/Lehman collapse. Changing the rate at which the dollar was convertible into gold was a primitive form of "quantitative easing" it basically created more dollars relative to gold.
After the second world war, in order to help the rebuild the economies of the anti-Soviet alliance we had assembled we established a global fixed exchange rate regime called the Bretton Woods Accords. This was a system of fixed exchange rates and capital controls. Bretton Woods effectively pegged the currencies of every country in the world to the dollar and pegged the dollar to gold. At the time the US was 45% of global GDP and the largest trading partner of every major industrial country, as a result at the start of the system it was a trivial matter for the US to function as the anchor. By the late 1960s the rest of the world had recovered, the global trading system as I have outlined in another post had recovered and advanced to levels never before seen. The Bretton Woods arrangements which had originally served to buttress the global free trading system began to hobble it, particularly its anchor, the United States. America had been fighting the Vietnam War and had embarked on a series of costly social programs which resulted in high levels of money creation which made the maintenance of the gold peg extremely difficult. Gold and silver began to pour out of the country. In 1968 the government stopped redeeming dollars in silver at a fixed rate. It threatened but did not destroy the Bretton Woods System because that was pegged to gold. Then in 1971 Nixon fully halted gold convertibility of the dollar which set the stage for the dissolution of the global regime of capital controls and fixed exchange rates. This in turn paved the way for the global fiat monetary system we have today. Keep in mind that though the government no longer pegged the dollar to gold, the whole time if continued to borrow, and repay, all its lenders in US dollars which were legal tender for all debts public and private in the United States.
So as you can see, all these episodes are the systematic detachment of the US dollar from the gold standard and are therefore devaluations. Ron Paul conflates them defaults. From a narrow perspective this is true. Let's say for the sake of argument that you were a hedge fund founded the year of the American Centennial in 1876. Let's further imagine that your strategy was that you would borrow gold, take that gold change it into dollars and then lend it to the US government thinking to yourself that, since the dollar was convertible into gold if anything went wrong you would simply sell your Treasuries, change your dollars for gold at the fixed rate and then pay back whoever had lent you the gold. If you had that strategy on in 1934, 1968, or 1971 you may well agree with Ron Paul that the US government had defaulted on you. After all, they were paying you back in dollars but those dollars were worth far less in gold terms than they had been when you originally borrowed the gold. You got smoked.
The question to ask, however, is how many people were in that position and did it damage the credibility of the Federal Government? Well, considering that the financial power of the age, Great Britain, had abandoned the gold standard in 1931 there was virtually no one in that position and given that in Bretton Woods all the worlds currencies were pegged to the dollar which was then pegged to gold, literally no US Treasury investor on Earth was in a position to be harmed by the US abandoning the gold standard. Yes, it was a devaluation of the dollar in gold terms and so if you were a holder of US Treasuries benchmarked to gold you would consider the US to have defaulted. But, since 1945 the dollar itself has been the reserve currency of the world it is pretty hard to think of the abandonment of the gold standard as a default. It was not accompanied by a reduction in the credit rating of the US or even of a mild disruption of the American ability to access global capital markets. Ron Paul's problem is that he looks at these devaluations and conflates them with default. He then draws the conclusion that since these defaults were not do bad that a straight up default would not be so bad either. Of course, as you can see, from start to finish these were not defaults and therefore Paul's logic is deeply, deeply flawed and massively underestimates the chaos which would result in a straight up de jure default on US Government obligations.
In his next two sections entitled “Unlimited Spending” and “Boom and Bust.” In them he makes the claim that once the US was off the gold standard it was free to borrow as much as it liked limited only by demand for Treasuries. He also concludes that the Federal Reserve is responsible for the business cycle through its control of interest rates. These assertions also have a tenuous connection at best to the historical record.
First of all, as we can see in the European periphery, there is indeed a point at which, even in a fiat monetary system, the bondholders will pull the plug on a sovereign borrower. Thus a fiat monetary system is not the blank check he claims. While it is true that the capacity of the US government to borrow is limited only by the willingness of investors to buy treasuries the US had a far far higher debt to GDP ratio in 1946 when we were still on the gold standard. For that matter the highest debt to GDP ratio in the history of the world that did not result in default (Great Britain, 1814, 225% of GDP) also occurred under a gold standard. So fiat money did not create the capacity for governments to borrow titanic sums. As far as speculative bubbles being the creation of central banks he might want to look over the history of the Dutch tulipomania which occurred in the absence of a central bank or the panics of 1857, 1869, 1873, 1893, or 1907 all of which occurred before the Federal Reserve Act to see that this is quite simply not the case.
Then comes his section on “Hard Decisons” and here the mistake Paul makes is a simple one of accounting, though it spectacular consequences. “It isn't too late to return to fiscal sanity,” he says, “we could start by canceling out the debt held by the Federal Reserve, which would clear $1.6 trillion under the debt ceiling.” This is simply ludicrous. Something to remember about The Federal Reserve Bank is that it is, as the name implies, a bank. This means it has a balance sheet. On one side of that balance sheet are the assets of the bank, among them $1.6 trillion in US Treasury securities, ordinarily considered risk free. Also on that side are another $1.3 trillion of other assets for total assets of $2.9 trillion. On the liability side there are $2.8 trillion in liabilities including $1.6 trillion worth of deposits from the nations commercial banks which they are required to hold at the Fed in order to ensure their safety and soundness and a mere $25 billion in equity. So guess that happens if you force the fed to write down $1.6 trillion in US Treasury securities because you have “cancelled them out.” You create a $1.6 trillion hole in the Fed's balance sheet which would, in effect, make the Federal Reserve Bank insolvent. THus it would be unable to redeem the $1.6 trillion in deposits back to the banking system and therefore transmit that insolvency to the entire banking system and from there to the real economy. This, of course, would be a major economic fiasco. Thus either the Fed would have to print $1.6 trillion, which I am sure Ron Paul does not envision with this plan, or the government would be forced to recapitalize the Fed to the tune of $1.6 trillion. Does the government have $1.6 trillion? No. It would have to borrow it, and we're right back where we started. I find it somewhat shocking that A.) Bloomberg printed this, and B.) there are people who think of it as a realistic possibility.
So Pauls theory is essentially that we have defaulted a lot in the past, that these defaults were not fatal, and that if we default today it will, in the short term, limit the access of the government to credit markets and therefore force the government to live within its means. Therefore, he concludes, default is the best option. This is of course absolutely insane, a straight up de jure default by the US would not only shut the US out international capital markets, but it would also obliterate the global fiat monetary system as well as force a massive repricing lower of every risk asset on Earth. Think of it in these terms, the post Lehman recession was two consecutive quarters of -6% GDP growth. The deficit is currently 12% of GDP, so a default which shut the US out of capital markets would be the equivalent of having all the financial turmoil for the fourth quarter of 2008 and the first quarter of 2009... in a day.
The other half of the problem with Ron Paul, is that though he is entirely wrong with his prescription for what ails the US, he is not wrong about the diagnosis. It is true that the net liabilities of US government entities at all levels are in the hundreds of trillions. It is true that no amount of “taxing the rich” will come close to financing them. It is true that the most likely outcome is serial inflations and defaults. Because these things are true he seems to have some credibility, indeed he is one of the few in Congress who grasp just how deep the problem is. Unfortunately, he is like Karl Marx, he has correctly identified the problem but his solution is destined to failure and catastrophe. He intends to rely on the bondholders to instill the discipline that he and his colleagues do not possess. But this is why we elect people like Paul to serve us in Washington. The right thing to do is to have the voters decide how much pain gets taken, by whom and at what speed. People like Ron Paul who would prefer to throw their hands in the air, and let the panicking bondholders decide those things are abdicating the very responsibility they have been granted by their constituents.
It is a crime against the country and the Constitutional order they feign to revere.