Fedus Ex Machina?

Was the Federal Reserve holding the Debt Ceiling cards all along?
Federal Reserve Board Chair Jerome Powell testifies before the Senate Committee on Banking, Housing, and Urban Affairs on 'The Semiannual Monetary Policy Report to the Congress', at Capitol Hill in Washington on Tuesday, July 17, 2018. (AP Photo/Jose Luis Magana)
FILE- In this July 17, 2018, file photo Federal Reserve Board Chair Jerome Powell testifies before the Senate Committee on Banking, Housing, and Urban Affairs on "The Semiannual Monetary Policy Report to the Congress... FILE- In this July 17, 2018, file photo Federal Reserve Board Chair Jerome Powell testifies before the Senate Committee on Banking, Housing, and Urban Affairs on "The Semiannual Monetary Policy Report to the Congress," at Capitol Hill in Washington. On Wednesday, Sept. 26, the Federal Reserve issues its latest policy statement and updates its interest-rate and economic projections before Powell holds a news conference. (AP Photo/Jose Luis Magana, FIle) MORE LESS
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From TPM Reader RC

You were wondering how Biden was able to get such a good deal; in the end all this drama just amounted to getting the budget-negotiation process started early, with the GOP’s main takeaway being something (spending freeze) that their control of the House already guaranteed them via the tool of passing continuing resolutions.

Joe did a far better job than anyone imagined he could, for about the 79th time in a row.  But that said, the key thing to recognize is that Biden’s hand was much stronger than anyone I read seemed to understand.  What the media got right is, if a default destroyed the economy, that would hurt Joe/Dems in the general; even if people in some sense knew it was the GOP’s fault, they’d still mostly follow the heuristic “if things are going well, I’ll vote for the incumbent; if not, throw the bums out!”

But consider this: what if a default _isn’t_ devastating for the economy?  And what if Joe and Kevin both know it?  Well in that case, default is fine for Biden, because he can then blame whatever economic difficulties occur between now and Election Day on the GOP-created default!  Of course not all such blame will stick, but the point is, if the default _doesn’t_ meaningfully damage the economy, then it’s a net positive for Joe’s re-election chances, because it means he’ll get at-least-a-little-bit reduced blame for whatever bad things (recession, slow wage growth, inflation, etc.) were going to happen anyway.

Presumably at this point you’re thinking, “sure, in that hypothetical Joe’s hand is strong, but we all know that a default would be a catastrophe surrounded by a disaster, wrapped in a calamity.”  But do we?  Take a look at the stock market — was it falling in fear of a crash as the deadline loomed?  Not so much!  Even better, look at the volatility index, or VIX, where investors can speculate on the probability that things get riskier.  It’s near the lowest level since before the pandemic.  The press focused on the fact that short-term Treasury bills reflected a significant default probability, but this is, in combination with the quiescent stock market and VIX levels, _comforting_ news.  It suggests we’re not in the situation that default would be catastrophic but it’s unlikely.  Rather, it says, sure, default might happen, but it won’t croak the market.  Because if default is reasonably likely, as the T-Bill rates suggest, and default _would_ croak the market, then we’d have seen stocks drop and implied volatility rise.  Since we didn’t see those things, it suggests the market thought default wouldn’t be a huge issue.

Now, by itself that’s not enough; financial markets aren’t always right.  Though surely the disconnect between the panic in the press and the total calm of the markets was worthy of a great deal more investigation than it received.  Journalists should have been asking themselves, “what do the markets know, or think they know, that we don’t?”  Here’s a likely answer: if all else fails, the Fed can solve the default problem, and they don’t need a platinum coin to do it.  All the Fed needs to do is… buy the defaulted bonds!

I know this seems so sinple as to be almost silly, but remember, buying bonds is something the Fed does on a regular basis; such activity is commonly referred to as “quantitative easing” or QE.  It’s just absolutely normal for the Fed to make bond purchases.  Of course traditionally QE meant buying the world’s safest assets, which is to say, rock-solid US Treasury bonds.  Whereas _defaulted_ Treasury bonds are somewhat riskier.  But not all _that_ much riskier, after all, everyone knows this debt limit thing will eventually get resolved.  And ever since TARP and all the other activities surrounding 2008 and it’s aftermath, it’s become quite normal for the Fed to buy _risky_ bonds, corporate bonds and the like; the TA in TARP stood for Troubled Assets.  Recall also that the Powell Fed committed to buy risky corporates during covid.  It just wouldn’t be weird at all for the Fed to say: if you have a $1000 bond maturing June 15 and the Treasury doesn’t pay it, we’ll buy it from you for face value.  the same with coupons. 

In truth the Fed might well get fancier and just commit to _lend_ the face value of bonds to people, collateralized by defaulted Treasuries.  There’s no doubt this is legal because this is _exactly_ what the Fed did during the recent regional-bank bailouts.  Indeed a cynic might say they did it precisely so that no one could say, come June, that such an action is novel or legally sketchy — it literally just occurred a month or two ago and no one had any problem with it.  I think the engineers call this a “smoke test.”

Now of course no one knows what the Fed would do in a default scenario.  Certainly Joe would not actually _prefer_ to default and find out.  But that said, I mean, can we really imagine Jerome Powell letting the global financial system collapse on his watch when he could easily address the problem employing tools he’s been using regularly since he took office?  Almost for sure he would step up.  The uncertainty is large enough to bring Joe to the negotiating table, but the near-certainty the Fed would save the day means Joe was holding aces.  He could say to McCarthy: look, I’m boring old Joe, so you know I’m not _hoping_ for default.  But if it happens, it’ll help me a bit in the general with 98% probability, and that’s sufficient to keep me from giving it all away in this negotiation.  Rather, I’ll give you just enough so you can tell your supporters you won, and bring a reasonable fraction of the GOP House caucus.  I’ll deliver the rest of the votes, and we’ll get back to business as usual.” 

Although this email has been long by 2023 standards, recognize that it’s hugely oversimplified.  The Fed bond purchases or loans do not, on their own, fully solve the problem; the Administration would need to take additional steps as well.  But it would solve the bulk of the problem, and other needed steps are well understood; e.g. continuing “extraordinary measures,” issuing Treasuries to pay Social Security and Medicare under the 1996 law that allows borrowing above the debt limit for this purpose, and so forth.

The Administration had access to a layered defense which includes paying the bonds while shutting down the government as a stopgap, just paying everything and saying he had to choose between breaking one law or another and chose the less damaging option, and other approaches, with the Fed as a final backstop.  But the Fed’s potential role is, I think, the key element left out of most discourse.  Understandably the Fed wants the President and Congress to work this out so will swear up and down until the last minute that they cannot help.  But this is obviously untrue; in fact the WSJ had a piece that glancingly mentioned how the Fed wargamed this scenario back in, IIRC, 2014.  It’s an option, and security prices suggest Wall Street knows it, which means Biden and McCarthy know it.

And that, plus Joe Biden being a talented people person who’s been getting deals done in Washington for half a century, is good at it and knows he’s good at it, will, assuming this deal passes Congress, be the reason he once more made fools of all the doubters.

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