Many do not realize this, but the Federal Reserve is the largest holder of US government debt. The Fed currently holds $1.625 trillion of US Treasuries alone, and this is the debt the Treasury is required to pay principal and interest on. This may seem uninteresting, given that the Fed is just an organization of the same government which owes the debt, but the real effects of this debt existing must be considered.

Congressmen and Presidential hopeful Ron Paul, who chairs the House sub-committee on monetary affairs says the Fed should not be holding this “ficitious” debt any longer against US tax payers. The issue becomes highly relevant when considered against the backdrop of Congressional dueling over the upcoming debt limit. On August 2nd, according to Treasury Secretary Timothy Geithner, the US will default on their financial obligations if they do not have their ability to borrow raised by Congressional decree. The reality of this threat has been challenged by some, recently Senator Jim Demint came out to argue what he saw as false threats from the Treasury Secretary. Nonetheless, the debt limit will soon arrive, and without spending cuts in the works, creative plans will be needed to avoid default.

Congressmen Paul’s proposal addresses this very problem. If the Fed retires the debt owed to them by the Treasury, the US debt will decrease well below the pending Congressional limit. If the US continues at current paces of borrowing expansion, the debt limit will be hit again sooner or later, but some time for serious cuts to occur will definitely be bought with the removal of that much debt from Government books. Interestingly, Congressmen Paul is not the first to suggest such a proposal. Paul’s mentor, famed economist Murray Rothbard once wrote:

“These [Treasury bonds] should be written off posthaste, since they are worse than an accounting fiction: the taxpayers are forced to pay interest and principle on debt which the Federal Government owes to its own creature, the Federal Reserve. “

The main opposition to a plan like Congressman Paul’s is that the Fed’s assets will be impaired and this makes an exit from their recent monetary stimulus more difficult. Furthermore, the Fed’s balance sheet would become technically insolvent and the Fed would likely be forced to turn to the Treasury to finance their operations.

Congressman Paul counters this skepticism by pointing out that the Fed is fully able to contract financial liquidity by raising reserve requirements. When the Fed raises reserve requirements, they force the banks to hold more liquidity at the Fed, thereby detracting from its use in the broader economy. The Fed also touts their ability to raise the rate they pay on reserve balances as having a similar effect, so the need for the Fed to sell rather than retire their Treasury claims is not necessarily required. Paul makes an excellent point as well that the Fed never declines their balance sheet size in trend, and a historical view of the Fed’s balance sheet growth signifies this. The first year after the Federal Reserve’s inception, their balance sheet was $330 million large while today the size is a whopping $2.9 trillion, an increase of almost 9000 times in less than a century. To expect the Fed to finally sell off assets on mass is extremely naive as odds are that assets they’ve purchased will be retained and compounded going forward, like they always do in the past. The same is likely true today because the Fed is the major support of the Treasury’s efforts to borrow more, as Congressman Paul points out, “we are technically bankrupt. The only thing that keeps us going on is counterfeiting.”

According to polls cited by Fox News, 69% of Americans say they do not want to raise the debt limit even though most are aware that the consequences of a default may be severe. The President and democrats seem out of line with the American public here as they say the debt ceiling must be raised and spending cuts are not an acceptable solution. Democrats prefer to continue borrowing but have “wealthy” Americans bare the burden of the cost by increasing taxes. Democrats contend the Republicans are using the debt ceiling vote as a weapon to acquire political votes, but the American public seems to think the level of government borrowing must not increase. Republicans, for the most part, have suggested that they require a balance budget amendment, no tax increases and serious spending cuts to bring them to the table on the debt ceiling vote. The wide disagreements between Democrats and Republicans have left a large level of uncertainty over whether or not the debt ceiling will be raised, as there is only three weeks left until the deadline hits. “I don’t see a path to a deal if they don’t budge. Period,” Obama recently told reporters.

See Congressman Paul’s full video interview where he notes the need for Congress to default to the Fed: