Things are starting to look pretty dicey with the US debt ceiling debate and government shut-down. If you watched the press conferences yesterday from Speaker Boehner and President Obama it looks like they’re both digging their heels in. They’re both waiting for the other side to blink as if this is some sort of staring contest that you might have had in kindergarten.
Anyhow, I’ve thought quite a bit about this and while things certainly look dicey I do think there’s a most likely outcome here. Here are my general thoughts on what might happen:
Scenario 1. (most likely): The market declines 2-3% further and credit markets start to show more signs of stress which causes the millionaires in Congress to look at their self imposed decline in net worth and come to their senses by passing a Continuing Resolution with both sides giving in a little bit to avoid having to look like this was all for nothing. But neither said will get 100% of what they want and we’ll bump right up against the debt ceiling before finally getting something done.
Scenario 2. (Unlikely) If Congress can’t come to an agreement before October 17th then Ben Bernanke will swoop in to save the day. Remember, the Federal Reserve was created specifically to avoid financial crises and to maintain a smooth operating payments system. And under the exigent circumstances clause the Fed Chief can basically do whatever is in his monetary control so long as he thinks it will avoid catastrophe. Given that a default would obviously cause a catastrophe the Fed, as the gatekeeper to the Treasury General Account, will work with the US Treasury to avoid a default. That means they’ll either perform some form of QE directly with the Treasury or they’ll just directly buy the bonds from the US Treasury with the agreement that they’ll sell them back for reissuance on the private market once the circus ends in Washington.*
The exigent circumstances clause is the cleanest and most logical way for the US government to avoid defaulting. And it avoids all the potentially messy alternatives like minting platinum coins or selling ultra premium bonds. And since President Obama would certainly place Ben Bernanke (and other voting members) at the top of a pardon list in exchange for this I see no downside for the Fed Chief. In fact, he’ll get to say he saved the world for the second time in 5 years. How many people can lay claim to that? No reasonable person could say the Fed broke the law under this environment when it was simply exercising its Congressionally granted exigent circumstances clause to save the country. And more importantly though, the US Treasury doesn’t have to be involved in breaking the law (which leaves the Executive Branch out of the equation).
In the case of exercising the exigent circumstances clause the US Congress becomes a moot point. Once the Fed is funding the US Treasury, Congress is just bickering for no reason because the central bank has effectively obtained the power of the purse. They’ve exposed the debt ceiling for the non-constraint that it is.
Scenario 3. (Also unlikely): If I were a consultant to Fed Chief Bernanke I would recommend that he call President Obama today and get certainty of a Presidential pardon in the case of breaking the Federal Reserve Act under exercising the exigent circumstances clause in case of a potential default. Then I’d call Jack Lew and tell him that I have his back no matter what and I absolutely will not let a group of maniacs in Congress cause a second financial crisis in 5 years. And then I’d call House Speaker Boehner and let him know that I will fund the US Treasury General Account in full on October 17th and inform him that his political leverage is gone. In other words, I would force scenario 1 by ensuring that scenario 2 is on the table. That would end the entire “crisis” because it would eliminate the leverage the House thinks it has over the Senate.
The bottom line is:
1) The US government will not default because, if the Congress can’t come to its senses, then the adults at the Fed and Treasury will simply circumvent their authority in an effort to avoid calamity. They have no choice because they either have to break the 14th amendment or the Fed Act (which is arguable to begin with given that the exigent circumstances clause is extremely vague).
2) Congress should be prudent and avoid putting the Treasury and Fed in an impossible position.
3) My hope, is that we’ll all look back at this in a few weeks and chuckle at how comedic our political process has become….
* The Exigent Circumstances clause, ie, the “all your base are belong to us” clause:
- In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorise any Federal reserve bank, during such periods as the said board may determine, at rates established in accordance with the provisions of section 14, subdivision (d), of this Act, to discount for any participant in any program or facility with broad-based eligibility, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank:Provided, That before discounting any such note, draft, or bill of exchange, the Federal reserve bank shall obtain evidence that such participant in any program or facility with broad-based eligibility is unable to secure adequate credit accommodations from other banking institutions. All such discounts for any participant in any program or facility with broad-based eligibility shall be subject to such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe.
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