Note to Fed: Get Out in Front of the Potential Debt Crisis

The consequences of the U.S. government defaulting, even if for a few days, could be significant. The long-term effect is that the U.S. economy could lose some or all of its ‘exorbitant privilege‘ which has allowed Americans for many years to live beyond their means. The short-term effect could be a major financial crisis as noted by Dick Bove over at FT Alphaville. Here is how he believe it could play out:

Money Market Mutual Funds

Should the United States government default virtually every money market mutual fund (MMMF) in the country would “break-the-buck” – i.e., be unable to pay investors 100 cents on every dollar invested. At present, MMMFs that do not actually earn enough money to pay back 100 cents on the dollar are subsidized by the fund management company. A Treasury default would make this virtually impossible and millions of Americans would lose billions of dollars.

Mutual Funds

The indentures of most bond and balanced mutual funds require that they immediately divest their holdings of defaulted securities. This could cause hundreds of billions in Treasuries to be sold immediately when the default was announced.

Depository Institutions

Let’s shift to another government document. This would be the FDIC’s aggregate balance sheet of the American banking industry… A reasonable estimate would be that the U.S. banking industry owns $1.85 trillion in government backed securities. It has $1.63 trillion in equity. If the Treasury and related securities were in default, one does not know what they would be worth. Assume a Latin American valuation of 10 to 20 cents on the dollar and an estimated $1.28 trillion in U.S. banking equity would be wiped out…In addition to the U.S. backed securities the banks own, they own an additional $1.27 trillion in other securities that would plunge in value… They have $7.73 trillion in loans which would also fall in value.

These developments would probably spill over into other markets. Such dire outcomes sound a lot like the concerns Fed Chairman Ben Bernanke had about the Eurozone Crisis back in 2011. Like now, I argued back then that Bernanke should get out in front of the Eurozone Crisis. Here is what I said:

So what can the Fed do? Here is a suggestion: the Fed could say if total current dollar spending begins to plummet because concerns about the financial system are causing investors to rapidly buy up safe money-like assets (time and saving accounts, money market accounts, treasuries, etc.) then the Fed would begin buying up less-safe and less-liquid assets until the investors’ demand for money-like assets is satiated such that they return total current dollar spending to its previous level. The Fed would need to stress the “until” part means it would purchase as many trillions of dollars of assets as necessary to restore total current dollar spending. Since this  process would take place over time, the Fed would also want to set a target growth rate for where it wanted the level of total current dollar spending to go.

If the above sounds reasonable to you, then you should be a fan of nominal GDP level targeting.  It is exactly what the U.S. economy needed in early 2008 when inflation expectations and velocity started falling.  And it is exactly what the  U.S. economy needs now.

So if the Fed wants to get out in front of the potential debt crisis, one important step it could take is to announce a NGDP level target. The Fed’s QE programs have been able to able to offset much of the fiscal drag over the past three years. A NGDP level target would step up the Fed’s game and make it better able to deal with the fallout of debt default. It would not solve all problems–for example, the U.S. might face permanently higher risk premiums–but it at least could offset any drag it might create on aggregate nominal spending. Now would be a great time to act.

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