Friday, July 29, 2011

End the debt crisis now with a credit default swap!


Lest anyone be confused, what follows is not a serious proposal. It's designed to show the absurdity of the current debt ceiling crisis, which is based on faulty views of what a federal debt ceiling actually accomplishes.

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President Obama has demanded a solution to the debt ceiling crisis by this Tuesday. He doesn't seem to like invoking the Fourteenth Amendment or creating jumbo coins. Congress can't seem to do anything. What's left?

Financial derivatives helped get us into the current economic mess. So why not use derivatives to get us out?

You may recall that in the years leading up to the 2008 financial crisis, investment banks bundled sub-prime mortgages into pools and issued mortgage backed securities. Various investment banks sold credit default swaps on these securities. Essentially, that means that they offered insurance that the amounts due on the underlying mortgages would continue to be paid. You'd think that the people who would buy the swaps (i.e., the insurance) would be owners of the underlying debt. In fact, anybody could buy them, and multiple people could buy insurance on the same securities. As a result, speculators bought the credit default swaps from the investment banks. In essence, they were buying short, paying relatively small premiums for insurance in the hopes that there would be a default.

As long as the housing markets boomed, investment banks were happy to offer the credit default swaps to speculators. They assumed that the mortgage backed securities they were insuring were safe, and so the premiums they collected from the speculators were like free money. But when the subprime mortgages began to default, the speculators demanded payment, which the investment banks couldn't meet meet. The house of cards began to collapse.

So let's make some lemonade out of these lemons.

The United States government debt is approximately 14.6 trillion dollars. There is a non-zero chance that the U.S. government will default on some or all of this debt. And given the debt ceiling crisis, that chance has increased.

So here's what Treasury Secretary Geithner should do. He should sell a credit default swap on the entire debt of the United States to the Federal Reserve Bank. The insurance premium will be 2 trillion dollars for six months.

If the U.S. keeps paying the bond holders during this six month period, nothing happens. But if the U.S. defaults, the Fed collects the entire loan amount on the defaulted debt.

The Fed pays for the credit default swap by crediting the Treasury's bank account with 2 trillion dollars. The Treasury can then pay the government's bills without increasing the debt ceiling. Crisis solved.

Of course, if the government defaults on its debt, it (and we) are in terrible trouble, because the Fed could demand payment of the entire amount of the underlying debt. But since the Fed is paying 2 trillion dollars up front, the government will have plenty of money to pay the bondholders. (And, if the government were to default, I'm sure it could work out something with the Fed, if you know what I mean.)

What this solution does, in effect, is use the sale of a derivative security instead of floating new debt ( currently prohibited by the debt ceiling), printing new currency (currently limited by other federal statutes), or minting new coins (the "jumbo coin" solution).

The credit default swap solution neither issues new debt nor creates new currency or coinage. It's the sale of a derivative security, or, if you like, the sale of an insurance policy.

The debt ceiling statute, 31 U.S.C. 3101(b), applies only to interest bearing "obligations." But I believe that the Treasury Secretary could easily argue that a credit default swap is not an interest bearing obligation under the meaning of the statute. It is either the sale of a derivative security, which does not fall under section 3101(b), or it is the sale of insurance, for which the government collects a premium.

Note that the government can do this multiple times. Every six months, it can sell a new credit default swap to the Fed for 2 trillion dollars; it's just like renewing an insurance policy. The debt ceiling need never be raised again. In theory, that is. In practice, selling credit default swaps may not be the best way to manage the national economy. It may be much sounder policy for the government to sell Treasury bonds as it has in the past rather than to keep replenishing the Treasury's bank accounts through the sales of made-up derivatives. But to get us out of the current crisis, it will do.

Has Secretary Geithner actually considered this plan? Could he put it into operation? Your guess is as good as mine. Just as with the jumbo coin solution, this is an exercise in fiscal science fiction.

Nevertheless, the credit default swap solution has a sort of poetic justice to it. We use the same techniques that helped get us into our current mess to help get us out of it. And, for the moment at least, we keep Congress from wrecking the U.S. economy-- and the world's.

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What's the moral of this story? It's simply this: American politicians appear to have a mystical belief about the importance of the debt ceiling. They believe that as long as Congress doesn't raise the debt ceiling, the government cannot spend more because it will run out of money. Faced with the threat of running out of money, the government will have to shrink the size of government.

But in a modern state that controls its own currency (unlike Greece, which uses the Euro) and has a modern central bank (like the Federal Reserve), the government never has to run out of money if it is willing to accept the economic consequences of government spending. It can always find ways to create new money: It can borrow money. It can print money. It can coin money. It can sell options on its property. Or, as in the case of this hypothetical, it can sell derivative securities that are not debt within the meaning of the debt ceiling statute.

The debt ceiling crisis is an artificial crisis. It is an unforced error, a self-inflicted wound. It will force us to make a weak economy even weaker, and for no good reason.

We shouldn't be in this situation; we should simply abolish the debt ceiling now. It has proven to be nothing more than a tool for foolish politicians to grandstand and in this case, to drive the country to the brink of disaster out of ignorance and ideological zeal.

Instead of fighting over the debt ceiling, we should focus on the real issues before the country: the proper amount and use of government appropriations and revenues, and the best way to lower unemployment and mend our ailing economy.

Read other posts on the debt ceiling crisis

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