Ron Paul’s ‘Free Lunch’ Would Be Costly

07/08/2011 9:45 am EST

Focus: MARKETS

Igor Greenwald

Chief Investment Strategist, MLP Profits

The Fed’s chief antagonist would have it cancel the federal debt it holds. It’s a fantasy that could turn into a nightmare, writes MoneyShow.com senior editor Igor Greenwald.

It's crunch time in Washington.

The nation's leaders are trapped in the sweltering capital trying to cut trillions in future spending as a condition for borrowing other trillions already spoken for. The populace is cynical, cranky, and paranoid that it's paying for some secret fringe benefit the stiff next door might not deserve.

Potential debt default is less than a month away, and President Obama (along with other worthies) is on record predicting a financial apocalypse if the debt ceiling is not extended.

But who's that quixotic hero charging into the mess on a white horse, with a plan to save the federal government $1.6 trillion at the stroke of a pen? Why, it's Rep. Ron Paul (R-Texas). Once a fringe Federal Reserve abolitionist, Paul has received a battlefield promotion to major presidential candidate and financial expert.

The longtime advocate for the gold standard has repeatedly criticized the Fed for buying Treasury bonds. But now he says this debt is to ourselves, and so doesn't need to be paid back.

And Paul is right, of course. The Federal Reserve could print out all the bonds it bought during QE1 and QE2 tomorrow and light a bonfire, wiping out its share of the federal debt. OK, so it might take an act of Congress.

Regardless, $1.6 trillion is a nice chunk of change to find under the bed. Granny might not need to take that Swiss vacation after all. Hedge-fund managers could stop house-hunting in Bermuda and the Isle of Wight.

Paul floated his debt-abolition balloon last week in an interview with conservative Iowa radio host Jan Mickelson. (Skip to the ten-minute mark on this video after the commercial.)

“We have to work hard to pay that interest to the Federal Reserve,” he said. “They're nobody. Why do we have to pay them off?...How did they pay for it? They printed the money out of thin air. So why don't we just eliminate it, and say we don't owe it to you any more?”

Mickelson followed up by asking whether this might not do further damage to the US credit rating, and Paul responded by arguing that this might actually reassure creditors by making Uncle Sam's remaining obligations more affordable. The entire exchange took maybe 90 seconds out of a half-hour interview.

Congressional colleagues and other fans of monetizing the US debt will have to wait for the PowerPoint followup. There's nary a peep about this debt-forgiveness plan on Paul's presidential Web site, nor the one devoted to his duties as a congressman.

Next: Why Paul's Plan Is Dangerous

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But desperate times call for desperate measures, and all that. Paul's trial balloon was immediately seized on by a media weary of the grim budget math and its implications for the economy.

Left-of-center economist Dean Baker pumped Paul's proposal at TNR.com as “surprisingly lucid” and “remarkably creative.”

This week, Time.com furthered the cause, wondering whether Paul might be “our savior.” (Not for nothing, the author of the column styles himself a “curious capitalist.”) His main qualm is that having the Fed cancel its bonds “just looks bad.”

Still, it's better than default or an austerity trap, he notes.

That's a lot of love for what is essentially a throwaway line. Paul is proposing the Fed cancel its bonds in the context of wanting to cancel the Fed.

As Time points out, interest on the Fed's bonds funds the central bank's operations, including the new consumer-protection agency mandated by the Dodd-Frank financial reform law. For Paul, monetizing the bond purchases he has railed against once and for all is a price worth paying for depriving the Fed of its primary revenue source, nothing more.

If stiffing the Fed on $1.6 trillion is such a great idea, why stop there? The central bank controls a truly limitless supply of electronic dollars. Why not have it buy up and wipe away all the outstanding US debt?

If Paul thinks creditors will like the US owing $1.6 trillion less, he must believe they'll love a debt-free America even more.

In real life, of course, this would likely prove another free lunch that wasn't.

With so much extra money loosed into the economy, inflation expectations would soar. The dollar might plummet, as China and other creditors look to move the proceeds from their Treasury bonds into other currencies before inflation really took hold. On that score, it would be better to increase the water temperature gradually, so as not to alarm the frog.

Then, too, there is the overwhelming likelihood that our representatives, freed from the constraints of the massive debt already on the books, would run it right back up again. There would be tax cuts and new spending programs galore, on the premise that the monetization exercise could be repeated.

But we likely wouldn't get that far.

  • The Fed's credibility would be shot, since it has made clear that selling the bonds it holds will be its first line of defense against inflation.
  • The cost of commodities would soar far above anything we've seen to date.
  • And, with big inflation on the horizon, overdue private-sector investments would likely be postponed.

There's no substitute for collecting enough taxes to pay for our spending, nor for saving for the rainy-day when the sun shines. Paul knows this, just like he knows his proposal is a fantasy.

The budget mess needs real solutions, not gimmicks that only serve to distract.

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