Federal Reserve Readies for U.S. Debt Default

by Jeff Reeves | July 21, 2011 10:22 am

Reports emerged last night that the Federal Reserve is actively preparing for a government debt default. With negotiations over the debt ceiling still going nowhere, it’s clear that Fed Chairman Ben Bernanke and his fellow central bankers don’t want to be caught without a plan.

There are just 12 days to go until the Aug. 2 deadline set by the Treasury, when the government will run out of money and stop paying some bills. And, barring a last-minute compromise, the U.S. will face at least a credit downgrade and at worst the label of outright default on its debts.

Yes, it has gotten this bad. And the Fed is preparing for the worst.

How did we get from the idea or threat of default to the point where the Fed is actually expecting such a disaster to occur?

There are a few reasons, but let’s cover the most pernicious: The political brinksmanship in Washington, D.C., has reached a new low. Yes, fiscal conservatives are correct when they say our massive government debts must change. And yes, social-minded liberals are right to protect the poorest and the oldest Americans who need government assistance most. We should all agree on that.

The hard part is finding a reasonable place to meet in the middle, where those competing interests can be balanced. But as we so often see in Congress, many spineless politicians have decided to take the easy way out by being stubborn and acting like it’s the other guy who’s being unreasonable — all so they can please their bases and hopefully get re-elected in 2012.

Personally, I find this nonsense totally irresponsible. I tried to highlight just how absurd things are with my recent satire piece that offered a Swiftian modest proposal: Kill our seniors.

But as the Aug. 2 deadline approaches, the seriousness of the situation is becoming quite clear.

So the Fed, not surprisingly, is making contingency plans. Some are just logistics: how to communicate with the Treasury and federal departments on which checks will bounce and which ones won’t if the debt debate isn’t resolved. The Treasury, after all, is just a department itself. The Federal Reserve actually clears the millions of Social Security payouts and government employee paychecks that get written each month.

But some Fed plans are downright scary if they become necessary. For instance, the Federal Reserve plays a crucial role in short-term lending to massive financial institutions. Fed “discount window” loans are offered to banks that hold Treasury bills as collateral. But in the event of a default or credit downgrade, those U.S. Treasury securities won’t have as much weight as a guarantee that the borrower is good for the loan.

“Do we treat (the T-bills offered as collateral) as if they didn’t default, in which case we would be saying we are pretending it never happened?” Charles Plosser, the president of the Philadelphia Federal Reserve Bank, mused in Reuters’ report. “Or do we treat them as if they defaulted and don’t lend against them?”

These are the serious and scary questions the Fed is facing, all because Congress can’t get its act together. The Treasury repeatedly has said default was unthinkable, but top policymakers clearly have begun thinking about it.

I don’t pretend to have an easy solution to our massive government debts, anemic economic growth and federal budget problems. But here’s the reality: This mess was created through shenanigans by Democrats and Republicans alike over decades. And while some folks believe the Treasury could make ends meet beyond Aug. 2, the bottom line is that, without a compromise, we assuredly will face a downgrade to America’s credit rating in the short term and a default sometime down the road. Maybe not on Aug. 2 but eventually.

President Barack Obama has tried to express the importance of shared sacrifice and compromise in negotiations. It’s a noble idea and one that our politicians should embrace.

But frankly, with each passing day, the most realistic outcome of the current politicking in D.C. seems to be a downgrade or default for federal debt.

What do you think about the debt debate? Share your thoughts in the forums below!

Jeff Reeves is the editor of InvestorPlace.com. Follow him on Twitter via @JeffReevesIP and become a fan of InvestorPlace on Facebook.

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