The Fed’s debt ceiling memo
It’s not debt ceiling season, thankfully: last June’s agreement suspends the ceiling until January of 2025. But there is a genuinely new data point about the issue, and I think it’s worth taking a look.
The core of the issue, in case you have forgotten, is that the US Treasury is subject to a borrowing limit imposed by the US legislature. Once total Treasury debt outstanding reaches that amount, the US may not legally continue to borrow. The main irony of this is that the US legislature is also responsible for determining tax rates and government spending, and the need to issue government debt is a consequence of those decisions.
Indeed, the US government budget is normally in deficit, so the amount of Treasury debt outstanding is normally increasing. This is why, every couple of years, the US Congress has to raise the ceiling. Lately, when a Democrat is in the White House, and Republicans control the legislature, the Republicans have pushed the process to the brink of crisis as a way to extract political concessions.
There are many things one can say about all this, but the most important one for Soon Parted is the fact that a binding debt ceiling could put the Treasury into default, meaning that the it would have payments coming due, but not have legal authority to pay them. The market for Treasury securities is the core of the global dollar-denominated market-based credit system, and so many people have wondered what might be the financial consequences if a debt-ceiling deal ever falls through.
That question in turn has much to do with what the Federal Reserve might do in the event of a Treasury default. The US central bank holds some $5 trillion in Treasury debt in its own portfolio, and moreover it is responsible for maintaining orderly conditions in the wider Treasury market. And of course the Fed has significant responsibility for financial stability more generally. So the Fed’s actions during a debt ceiling crisis would be of central importance.
As of a couple of months ago, thanks to a FOIA request by Nathan Tankus, we now have a lot more concrete information about what the Fed thinks it would do in the event of a default. In July 2011, during a moment of debt-ceiling speculation, two officials on the Fed’s Open Market Trading Desk put together a plan for what to do if the Treasury defaulted.
The memo lays out 10 possible tactics for responding, organized by how much new authorization would be required to carry them out. What is quite remarkable (though I cannot say it is surprising) is that items 1 through 5 are different versions of “ignore the default.” For example, Desk procedures allow the purchase of defaulted securities. The Fed’s willingness to continue buying, even after a default, would likely be a meaningful signal to other market participants. The Fed has a fair amount of discretion to determine what it buys and sells and what it accepts as collateral, so the fact that the borrower has defaulted need not be an obstacle, even if that borrower is the US government itself.
Another example: the Fed conducts securities lending as part of its normal operations. The memo’s authors believe there is nothing stopping the bank from lending out non-defaulted securities and accepting defaulted securities as collateral. Likewise, the Fed could lend money against defaulted securities.
Items 6 through 8 point out that, with FOMC authorization, the Fed could lend money or securities into the market to address particular disruptions, though it is hard to know exactly what those disruptions would be. And items 9 and 10 suggest that the Fed could use its own balance sheet to take defaulted securities out of the market.
The main point, I think, is that the mere fact of a US default need not cause global finance to grind to a halt. The Fed, at the center of global financial flows, has considerable leeway to continue to operate even after a US default. The gravitational pull of the continuity of normal flows of borrowing and lending is incredibly strong, and ignoring an inconvenient fact like a default is arguably the most straightforward response we could imagine.
Importantly, however, and in contrast to Tankus’s view, I caution against the conclusion that this memo gives the executive the freedom to ignore the debt ceiling altogether. It’s true that the Fed could and would suspend the rules to prevent a Treasury default from spilling over. This does not amount to breaking the rules, or changing the rules. In the event, we would know this from the intense air of crisis that would surround each of the Fed’s actions. Behind the scenes, the pressure on Congress to resolve the issue would be unimaginable.
The Fed can pretend the rules don’t exist only while the Treasury continues to pretend to follow them. If a future US president were tempted by this memo to simply ignore the debt ceiling, to instruct their Treasury secretary to keep paying come what may, it would be a blatant disregard of the rules. The house of cards would come down, rather quickly I think.