Earlier this week, I wrote a piece explaining why I am skeptical on the idea of repudiating government debt owed to the Federal Reserve.  Ron Paul suggested the idea and Lew Rockwell backed it.  These two guys are libertarian heroes and I immensely respect their opinions.  I rarely disagree with Ron Paul on issues of any significance, particularly when it comes to monetary matters.  With all of that said, I am disagreeing with his suggestion to repudiate the debt owed to the Fed.

I was having this discussion with a libertarian friend of mine.  I was saying that I thought the idea was inflationary.  I pointed out Ron Paul’s position that he figures that the Fed will not withdraw this money that it has artificially created.

I think this idea is also counterproductive.  If the debt ceiling does not get raised (which I think it will), then it will force the government to cut spending drastically.  That is what I favor.  That is what the economy needs.  We need for the government to spend less so that we have more.  If this debt to the Fed is repudiated, it will give the government more room to spend money without raising the debt ceiling right now.  Why would I favor that?  I would much rather see government spending cut.

But here is the even more important point regarding this issue.  My friend and I talked through this issue and this example will really illustrate why this is a bad idea for libertarians to support.  Let’s say that the government takes this idea and repudiates most of the debt that is owed to the Federal Reserve.  Let’s say this lowers the national debt to $13 trillion.  The limit is currently just under $14.3 trillion.

Now the Congress can continue to spend money as it has been doing.  It will use current tax collections to fund spending and any difference is added to the debt.  Now the Fed comes along with QE3 and buys this government debt to fund the extra spending.  Now, in the matter of less than a year, the national debt is back up to the ceiling of around $14.3 trillion.  The Fed now owns another $1.3 trillion in government debt.  The government can just repeat the process and repudiate this debt and bring the national debt back to $13 trillion.

Are you starting to see the problem here?  The Fed can keep buying government bonds to fund the excess spending and the government can keep repudiating the debt.  It would be the same thing as the Fed just printing up a bunch of money and handing it over to Congress to spend.  It doesn’t raise the debt because it is all done through inflation.

If the government did not want to officially repudiate debt, there is another strategy that could be used (not that I’m trying to give any ideas here).  The Fed could buy other assets and turn them over to Congress.  The Fed typically buys U.S. government debt, but the rules have changed and the Fed can actually buy anything it wants.  In 2008, it bought “toxic assets” from the failing banks.

The Fed could buy some stocks, land, art, or whatever.  It would create money out of thin air to buy these things, just as it does with government debt.  Then it could take the stocks or land or whatever and “give” it to the government.  The government could then sell it back into the market and use the proceeds to fund excess spending.  No matter how it is done, it is highly inflationary.

I hope I have illustrated why this idea of repudiating government debt owed to the Fed should not be such a great idea for libertarians.  It allows the government to continue its reckless spending without raising the debt limit and it could also be highly inflationary, especially if they were to repeat the process in the future.  I might favor the idea if it goes hand in hand with abolishing the Fed.