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We’ve become bored of used to the perpetual prospect that self-inflicted political ineptitude in the Land of the Free might take the world’s ultimate ‘safe asset’ into default. Yes, this could wreak havoc and devastation across the financial system, bring about the end of days, etc etc.
Thankfully, Congress punted the issue into the long grass of January 2025, granting us all a holiday from having to analyse this painful effort of performative political narcissism.
TK REWRITE: But even though the default discourse usually gives off more heat than light, some genuinely new and interesting details emerged today, via Nathan Tankus.
In an op-ed for Politico earlier this year, Tankus speculated about the various options that the US Treasury might deploy in the event that the debt ceiling was hit and a default ensued. From minting a trillion-dollar platinum coin, to switching to issue low-face-value-stupidly-high-coupon bonds, the US government is not short of tricksy wiggle-rounds — although the reputational cost of deploying them remain unquantifiable.
Tankus found a reference to a memo on ‘Potential Policy Responses to the Debt Ceiling’ prepared for the FOMC back in 2011. He put in a FOIA request and — ta-da — here it is on the Fed’s website!
What are the main takeaways?
First, the Fed’s staff recommended that the central bank buy defaulted Treasuries as part of their (then ongoing) QE:
. . . unless otherwise directed by the Committee, the Desk intends to accept defaulted securities in these operations in the same manner as other Treasury securities, with the prices determined through competitive bidding.
Second, they said the Fed could continue lending out securities as if the US hadn’t defaulted:
Market participants might want to offer the Desk defaulted Treasury securities in exchange for other (non-defaulted) Treasury securities in the Desk’s regular securities lending operations. They may be particularly inclined to do so if defaulted securities were experiencing poor liquidity in cash or financing markets, or if such securities were facing higher haircuts or exclusion as collateral in other transactions. Allowing dealers to conduct this exchange would support their ability to maintain regular activities in the market. Unless the Committee directs otherwise, the Desk intends to accept defaulted securities in its securities lending operations, and the defaulted securities taken as collateral in these operations would continue to be assigned full market value with the same haircuts as non-defaulted securities.
Third, it could accept defaulted USTs as collateral for repo operations . . .
If such operations prove necessary, the Desk intends to accept defaulted Treasuries as collateral at market prices and on the same terms as non-defaulted securities, unless otherwise directed by the Committee.
. . . and as collateral for discount-window lending:
The discount window could serve as an effective vehicle for providing such funding directly to these institutions. In these circumstances it would seem appropriate for the Federal Reserve to accept defaulted Treasury securities as discount window collateral with appropriate valuations and haircuts.
Staff planned to set up these contingencies unless otherwise instructed by the FOMC.
But they also presented a few new policy options. Two in particular are worth dwelling on.
One envisaged money markets potentially breaking the buck and suffering investor flight, and suggested new liquidity facilities to cope:
It is possible that Treasury-only money market funds could experience a decline in the value of their holdings or missed principal and interest payments on those holdings. At the same time, they could face redemptions as concerned investors pull away from all investments related to Treasury securities. This combination could create a liquidity squeeze for those money market funds, potentially leading to abrupt sales of Treasuries into distressed markets at inappropriate prices. In such a situation, a facility might be developed to provide liquidity to money funds.
Another was “outright purchases” of busted USTs that would “remove the securities from firms’ balance sheets, so that the firms no longer have to deal with the operational issues associated with defaulted securities.” The staff also noted:
. . . such an approach would insert the Federal Reserve into a political situation and could raise questions about its independence from debt management issues faced by the Treasury. Thus, the staff assumes that the FOMC would not be interested in pursuing these options, but they are presented for completeness.
What did Powell make of these options? As Tankus found on a transcript from an October 2013 FOMC conference call, Powell reckoned these options were “loathsome.”
Loathsome!
So loathsome that he wouldn’t consider them? Let’s follow Tankus back to that October 2013 transcript:
MR. POWELL: As long as I’m talking, I find [these options] to be loathsome. I hope that gets into the minutes. (Laughter) But I don’t want to say today what I would and wouldn’t do, if we have to actually deal with a catastrophe on this.
CHAIR BERNANKE. So you are willing to accept “loathsome” under some certain circumstances. (Laughter)
MR. POWELL. Yes, under certain circumstances.
So now we know!
Tankus reckons this aligns Powell with a course of action compatible with taking a trillion-dollar platinum coin as collateral, fulfilling its legal obligations as the government’s banker.
We’re not quite as sure that it’s a clear slam dunk, but we’ve got to give him credit for unearthing this gem of a memo.
