The Fed and the Debt Limit

What's the matter with a temporary delay in paying interest and principal on debt, if the debt limit hits? Collateral. Financial institutions can easily borrow using treasury securities as collateral.  If a treasury is in technical default, it suddenly can't be used as collateral, or you can borrow much less money with it. Thus even a technical and temporary default, even if we all know Uncle Sam will eventually repay the debt, is dangerous to the financial system. (Why we have so much short term collateralized borrowing is a topic for another day. We do, and unwinding it suddenly would be bad.) 

Earlier I argued that the Treasury should stand up and say "we will pay interest and principal on Treasury debt before we pay anything else." It's important to say that now to avoid a run. I suspect they will do it in the end, but want to use the threat of a crisis to get Congress to raise the limit promptly. If so, they're playing with fire, as runs start ahead of time. 

Today, however, I've been thinking about what the Fed can do. First, the Fed can say right now, in the event of a debt ceiling technical default, we will suspend all our rules and allow financial institutions to lend against treasury collateral with customary (tiny) haircuts, ignoring the technical default. Second, the Fed can say it will lend freely against treasury collateral to banks, or via reverse repos to financial institutions, with no haircut, even if the securities are in default. Third, the Fed can say it will buy Treasurys. It will fix a low rate of interest and buy all anyone wants to sell at that price. Will private markets make some money off this? Yes. Fine. That's the point. Hang on to your treasurys, you'll make some money is a lot better than starting a crisis. If the Fed overpays, it just remits less to Treasury eventually. 

Say it now, so there is no run as the debt ceiling approaches. 

The one thing Fed and Treasury will clearly not be able to do under a debt limit is to run another big bailout. So make darn sure we don't need one! 

What about the trillion dollar coin? Clever, but as before, issuing interest-only debt is even more clever. The debt limit only counts principal, not market value, so interest only debt doesn't count! But both that and the trillion dollar coin are so obviously against the spirit of the debt limit, that if Treasury is worried about its authority to prioritize treasury debt over (say) electric car subsidies, then either is not worth discussing. 

from The Grumpy Economist https://ift.tt/KJ0eyls