Say what you will about Paul Krugman, he doesn’t use euphemisms to hide what he’s proposing. Most (in)famously, he once said on CNN that it would be easy to exit a deep recession if only Americans (erroneously) believed they were about to be invaded by space aliens. Love him or hate him, Krugman distilled the essence of Keynesian fiscal analysis down to a crisp illustration.
In the current debate over the debt ceiling, Krugman performs a similar public service. Most people are arguing over the “trillion dollar platinum coin” — see my 2011 analysis here — but in a series of recent tweets Krugman explains the magic trick involved with a proposal to use so-called premium bonds:
I thought it would be useful to spell out exactly what Krugman is saying here. Consider a scenario where the government wants to spend $1 trillion more than it receives in tax revenue over the next few months. Normally the Treasury would just issue $1 trillion in new debt, but further suppose we’re hovering right below the current debt limit.
Rather than argue with Republicans in Congress, the White House tells the Treasury to issue legally binding contracts that entitle the bearers to collectively receive $50 billion in payments every year from the Treasury, forever.
Now suppose that private sector investors evaluate the likelihood that the US Treasury will indeed pay $50 billion per year forever. (Note that this consol is an infinite-term or perpetual bond, a type of instrument that was actually issued by the British government in the 18th century. Today the longest bonds issued by the Treasury have 30-year maturities.) Taking into account the risk of future default, the investors decide to discount the promised flow of payments at an annual rate of 5%. That makes the present-discounted value of the stream of payments $1 trillion, which the investors hand over to the Treasury.
In other words, in this scenario the Treasury auctioned off legally binding promises to pay out $50 billion in extra interest payments every year forever, and in exchange received a lump-sum loan of $1 trillion. It could then use this influx of cash to cover the deficit, funding the uncovered spending without having to raise the debt limit.
Putting the Rabbit in the Hat
“Wait a minute!” you might object. “Didn’t the outstanding federal debt just go up by $1 trillion? Isn’t this illegal if the Congress didn’t raise the ceiling?”
But this is the magic trick; it’s what Krugman was alluding to in his tweets above. Right now, with Treasury notes and bonds that have coupons, lenders buy the securities at auction for their “face amount,” and then the implicit yield on the security (or interest rate on the loan) is determined via the auction process itself. (See this video for a good introduction to the basics — and yes the creators rely on an MMT author, don’t let that stop you.)
So in a standard Treasury auction, because the interest rate on the loan is set through competitive bidding, at the moment of the sale the purchase price equals both (a) the face value of the security and (b) the actual market value of the security, taking into account the promised future cash flows and the “market rate of interest” as it was just determined in a snapshot at the auction.
Therefore, when we want to know how much typical Treasury auctions add to the gross federal debt, it’s fine to simply keep track of the par value of the securities that have been issued. (Things are a little trickier with short-term Treasury bills that don’t have a coupon, but we’ll ignore that complication.) So for example, when a new $1,000 Treasury bond is issued, that adds $1,000 to the federal debt and counts towards the debt ceiling.
But with a premium bond as suggested in Krugman’s tweets, the Treasury isn’t letting a competitive procedure determine the yield. Instead, the bond has (say) a face value of $1,000 that will be returned upon maturity (after 30 years, say), but in the meantime the bond pays $100 each year. That is an implicit yield far higher than the actual market rates on 30-year Treasury bonds.
As of this writing, the yield on 30-year Treasuries is 3.8%. At that discount rate, a bond that pays $100 for 30 years and then gives back $1,000, would have a PDV of about $2,100. So investors at auction would be willing to lend $2,100 to the Treasury for this 30-year “premium bond,” but since its face value would only say “$1,000,” the Treasury could plausibly argue to the Supreme Court that this bond should only be valued at its “par value” like the other bonds, i.e. $1,000.
In other words, in this particular example, the Treasury could effectively borrow $2,100 while only raising the debt by $1,000. So as a legitimate, old-school bond with a face value of $1,000 matured, the Treasury could roll it over into a new, premium bond with the same face value, but rather than receiving merely $1,000 from lenders it would fetch $2,100, granting an extra $1,100 to spend free and clear without raising the debt ceiling.
In the limit, if the Treasury pushed the maturity out forever and issued perpetual bonds (consols), then there would be no “face value” or “par amount” to contribute toward the debt ceiling. The Treasury wouldn’t even need to go through the motions of replacing existing federal debt with the new issues; they could issue consols and spend the entire proceeds immediately, arguing that they have no face value and hence don’t add a single penny to the “national debt.”
Conclusion
I hope my walk-through above has shed light on the accounting gimmicks that, alas, even economics Nobel laureates are cooking up to evade the debt ceiling. Regardless of how things shake out in Washington, it should be clear to sober members of the financial community that we need to develop alternatives to the traditional vehicles to store and transmit wealth.
We are doing our part to create new solutions, namely by marrying Whole Life insurance with blockchain technology. To learn more please see the infineo website.
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