Will there be a Fed shutdown?

Greg Hannsgen | July 28, 2011

In a recent blog piece at the CNBC website, John Carney offers this interpretation of the federal debt ceiling (see also Felix Salmon’s more recent comment):

“The debt ceiling applies to the face amount of obligations issued under Chapter 31 of Title 31 of the U.S. Code—basically, Treasury notes and bills and the other standard kinds of government debt—and the “face amount of obligations whose principal and interest are guaranteed by the United States Government.” But overdrafts on the Federal Reserve wouldn’t be Treasurys and they aren’t explicitly guaranteed by the U.S. government.

“They’re more like unilateral gifts from the Fed.

“And guess what? The Treasury is allowed to accept gifts that “reduce the public debt.” Since these overdraft gifts from the Fed would allow the government to spend without incurring additional debt, it seems very plausible to argue that this kind of extension of U.S. credit would be permitted under the debt ceiling.”

In normal times, when the federal government has not reached a Congressionally imposed ceiling on its debt issuance, the Fed would indeed honor all checks issued by the U.S. Treasury Department, whether or not Treasury securities had previously been issued in sufficient amounts to “cover” the checks.  Carney may indeed be right that the debt limit law might permit this to continue after the debt limit has been reached on August 2. As pointed out by Carney, the legal issue would seem to turn on the question of whether the “overdrafts” to which he refers would be equivalent to federal debt under the relevant legislation.

In my opinion, this would be good news, as federal debt limits are not helpful to the public interest. I have one additional thought to mention. In Carney’s scenario, it would be likely that banks would begin to accumulate excess reserves at the Fed, where they now earn one-quarter percent interest. Hence, a large portion of the reserves created by the Fed to cover expenditures that would otherwise breach the debt limit would become earning assets for banks, with the Fed paying interest on these liabilities. Legally, of course, reserve deposits at the Fed are liabilities of the Fed and not the federal government.

Also, as Carney points out, banks and recipients of new government checks would seek to purchase existing fixed-income securities with some of the newly created money, probably putting downward pressure on yields. The Fed could then try to keep interest rates from falling by selling securities from its open-market portfolio.

Hence, in Carney’s scenario, the Fed would most likely increase its liabilities and/or decrease its asset holdings by large amounts, a process that would in a sense compensate for the lack of new Treasury-security issuance.  The question is whether this would be legal if the debt limit law was at issue.  If the overdraft strategy turns out to be legal and acceptable to the main players, we could have a far better situation than one in which the federal government could not pay for its normal operations.

Clarification, July 28: It should be duly noted that while August 2 is regarded as the hard-and-fast deadline for raising the debt ceiling, the federal government actually reached its debt limit in May. New debt issuance ceased at that point. The federal government has continued to pay its bills using “extraordinary measures” that were recently outlined by Treasury Secretary Geithner in materials posted here. These measures involve temporarily tapping certain government funds set aside for various purposes. The government has estimated that these alternative ways of funding government expenditures will be exhausted on August 2; hence, this is the date by which the resolution of the current impasse must occur according to the administration. This somewhat technical point was misstated in the post above, which implied that the legal debt limit would not be reached until August 2. We apologize for any confusion this may have caused. -G.H.

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