Are Federal Reserve Notes And Treasury Debt The Same Thing?

My respected friend pgl at Angry Bear dumps on Charles Krauthammer for saying this:

2042 is the fictional date for the fictional bankruptcy of a fictional trust fund. Let's start with basics. The Social Security system has no trust fund. No lock box. When you pay your payroll tax every year, the money is not converted into gold bars and shipped to some desert island, ready for retrieval when you turn 65... These pieces of paper might be useful for rolling cigars. They will not fund your retirement. Your Leisure World greens fees will be coming from the payroll taxes of young people during the years you grow old. That is why 2042 is a fiction. The really important date is 2018.

pgl trots out a pretty clever argument.

If there are Federal Reserve notes in your wallet, I’ll gladly buy you a cup of coffee if you give them to me.

If you really believe piece of paper called financial assets are worth nothing, I’ll gladly take all of your cash, funds in your bank accounts, and other financial assets. In turn, I’ll even buy a week’s worth of groceries.

Clever, but not apt, I think, because modern institutions really do imply different expectations about the liability represented by a Federal Reserve note compared to that represented by a Treasury security.

Here's what I mean.  I think it useful (and appropriate) to think of my economic relationship with the government in terms of the totality of our financial interactions.  In other words, my net tax burden does not just consist of my social security taxes, or my income-tax payments, or what I remit in Medicare "premiums", etc., etc., etc, but the present value of all my payments to the government less all the payments they make to me.  (This is the fundamental  idea behind the concept of generational accounting, of which I am a very big fan.)

Suppose I hold a Treasury security. That, of course, is a payment the government owes to me, and I have every expectation that it will be made.  But if, for some reason, there has been a miscalculation, a change in economic circumstances, a change in policy, the government may find that it has to raise my taxes to obtain the revenues to honor those payments.  In doing so, it has effectively reduced the return on that security.  Distortionary price effects aside -- granted, a major qualification -- why should it matter to me how it happens?  Lower my social security benefits, raise my income taxes, whatever.  It all amounts to a haircut on that Treasury payment to me. 

Because the distributional aspects of these things can matter, blanket haircuts are probably a pretty bad idea -- foreigners, for example, finance a good chunk of our collective borrowing, and they aren't likely to appreciate the opportunity to finance our fiscal imbalances on an ongoing basis.  Changes in tax and transfer policies are the way we go because they can be targeted (which gets us to positive versus normative questions, which I'll address below.)  But the basic economic distinction is one without a difference.

Why are Federal Reserve notes different?  At some level, they aren't, as pgl has reminded me on numerous occasions.  One way to truly implement a haircut on government debt is to reduce the purchasing power of the currency in which the debt is paid -- by employing, in other words, the so-called inflation tax.  But the United States, and almost all developed countries, have worked hard to ensure people that this won't happen.  This is why the Fed is largely independent of the Treasury.  In essence, we have guaranteed that fiscal imbalances won't be addressed by reducing the value of Federal Reserve notes.  Despite protests to the contrary, no such promise is made for the return to Treasury notes, as the ever-changing tax rate on interest income makes abundantly clear.

Now to Krauthammer's point.  Here we, again, we have the unfortunate confluence of positive and normative assertions.  I think Krauthammer is making the positive point that private debt and equity supports investment. In many cases, public debt supports consumption, and there is a big difference between these two situations.  Of course, you may want to argue that, at the margin, the bulk of public expenditure is actually investment (and more productive than private investment).  That is an assertion that can be adjudicated by evidence, and I'll listen  But there is no fallacy in Krauthammer's assertion.

Then there is the normative question -- whether is right to renege on the government payments promised (and planned for) by retirees and near-retirees.  On this, pgl and I (and President Bush) agree that the answer is "no."

UPDATE: An update at the original Angry Bear post, and more at William Polley.