What if the US reaches the debt ceiling and there’s no deal? Will the US default? No worries. Ben Bernanke has the keys to the printing presses and he can solve the problem in no time. Sounds absurd? All the options are on the table. Also on the debt ceiling.
At the time of writing, the chances for a political deal on raising the debt ceiling and cutting the deficit in the long run seem more feasible. Perhaps the warnings from Moody’s and S&P about a downgrade will push lawmakers in Washington to make a push. But it is not over yet:
In the art of finance, there is no such thing as no such thing.
The Federal Reserve ended the QE2 program and is now only reinvesting in maturing assets. This program, sometimes called QE2 Lite isn’t enlarging the balance sheet, but for every bond that matures, it buys others. This way, the amount of stimulus remains unchanged.
When the economy improves, the Fed will let them mature and squeeze the balance sheet. An improvement in the economy seems quite far at the moment.
Reinvestment
How about investing in maturing assets that are about to mature very soon? Those that are about to mature from August 2nd for example?
As the US government approaches the debt ceiling, the virtual printing presses of the Federal Reserve could come into action. The Fed already owns a nice piece of US government debt, but there’s always room for more.
So, the Fed can buy bonds that the government cannot pay back from external investors. These investors, such as the Chinese, will get the value of their bonds. No default for them.
If no one from the outside suffers, the global recession that was warned of is off the cards.
Internal Default
So now, the government has to pay the Federal Reserve, but it can’t as it passed the debt ceiling. So it defaults to the Federal Reserve, and the Fed accepts it.
Sounds like fiction? Perhaps. But this is certainly a possibility. Ben Bernanke didn’t rule out buying defaulted bonds. In an official testimony in Washington said it is up to the FOMC as a whole.
So, the Fed doesn’t get paid by the government, and that’s quite alright, in its weird way.
This will just shrink the balance sheet of the Federal Reserve, and will justify buying even more bonds. Some things must be balanced!
What’s next?
The next meeting of the FOMC is on August 9th, but they can always call an emergency meeting or discuss this in a video conference. It already happened in the past and it can be easily arranged.
I don’t think the situation will reach this stage. Politicians are politicians and they like to reach a deal at the last moment. The fact that Bernanke didn’t rule out holding defaulted bonds serves as another means of pressure, together with the credit rating warning from both Moody’s and S&P.
But who knows…
Further reading: Moody’s in a mood for overcompensation.
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