I have been on a crash course to try and understand the arcane details of what options are available if the current debt ceiling is reached with no action taken to raise it and the balance in the government’s account actually becomes zero. I thought I would share what I have learned so far.

We tend to think of the US government as having a checking account, just like many of us, and of the debt ceiling like a loan given to us by a bank. This is mostly true, except in one significant way that I will get to below. This informative article by John Carney says that the government does have something that looks like a checking account in which all the money it receives continuously (tax receipts, air transport security fees, the postal service, Medicare premiums, etc.) is deposited and from which all its payments (federal employee salaries, income tax refunds, NASA, interest on our debt, unemployment insurance benefits and paying defense contracts) goes out. To get an idea of the scale of transactions in that account, at the beginning of last Friday, the account had $83 billion and during the day it received $7 billion in deposits and paid out $13 billion in withdrawals, leaving it at the end of the day with $77 billion. When the debt ceiling is raised, the balance of money available for use in that account is effectively increased by that amount.

Will not raising the debt ceiling actually result in the US government not being able to meet its obligations? If the US government’s finances are really like our own checking accounts, it would seem that once the balance in the account reaches zero, we run out of money to spend and cannot write any more checks. If we do, they will bounce. That means that the government will have to make hard decisions about what obligations to meet and what to ignore, limiting its outlays only to the amount of money that comes in. And if it cannot meet all its obligations this way, it goes into bankruptcy.

But this is where the government differs from you and me, because the government has a really, really special relationship with its bank. The Federal Reserve Bank of New York is the place where the government’s checking account resides. It appears that the government is not forced to stop paying any of its obligations even if the amount in that account becomes zero because when the government (i.e., the US Treasury Department) writes a check payable to someone who then deposits it in their own bank, the check works its way through the system and ultimately goes back to the Federal Reserve (the government’s bank) for cashing and it is next to impossible that they will not honor a US government check and thus cause it to bounce. As Carney says:

It’s not clear that the Federal Reserve would be required to clear a check that exceeded the amount on deposit. It may be within its authority to reject the check.

But rejecting a check written by the government of the United States would probably violate the dual mandate of the Fed to pursue maximum employment and price stability. A U.S. government that bounced checks would just introduce so much chaos the Fed would likely be obligated by its core mandates to credit the check.

To restate it in personal finance terms, by honoring the check even if the balance in the account is zero, the Federal Reserve would be giving the US Treasury the equivalent of free overdraft privileges. This is similar to the way that some regular banks treat their best customers, confident that the money will be paid back in the future. Of course, banks can sometimes get nervous about the financial state of even the most seemingly sterling customers and shut down this overdraft privilege but it seems unlikely that the Federal Reserve would do that to the US Treasury except under the most catastrophic circumstances, such as the US government running completely amuck.

Notice that this would do something very odd. It would give the U.S. Treasury Department control of the money supply—something usually credited to the Fed. But by writing checks on an empty bank account, the Treasury would be inflating the money supply. It would be printing money to pay its bills, more or less.
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So the Treasury cannot actually run out of money. It can only run out if it decides—that is, if Secretary Geithner and President Barack Obama choose—to stop writing checks sufficient to pay all of our obligations.

By a curious coincidence, the person who would write the checks (current US Treasury Secretary Timothy Geithner) was, before he took his current job, the head of the Federal Reserve Bank of New York, which is the US government’s banker and would be the body that decides whether to honor the checks or not.

So how will the Federal Reserve honor the checks of the US Treasury if there is no money in that account? Ordinary banks, faced with such a situation where a valued customer writes a check that exceeds the money on deposit, can honor the check using the money it holds of other depositors or borrow money from other banks or the Federal Reserve. The Federal Reserve system also has deposits of other banks that it can use to honor the US Treasury checks but has an additional way of producing money that ordinary banks do no have. It can order the printing of money.

So default seems to not be the inevitable consequence of not raising the debt ceiling, which may explain why governments around the globe are not (as yet) panicking and stock markets are not (as yet) tumbling at the prospect of a US default. Maybe they understand these things better than we do or they don’t understand but think that Congress will ultimately raise the ceiling before the deadline.

The legislation governing the US debt is called the Public Debt Act and was passed in 1941. As I understand it (and I may well be wrong), it forbids the US Treasury from going into debt higher than a limit set by Congress. i.e., the US Treasury is forbidden from selling (through the Federal Reserve) Treasury bills, notes, and bonds that would bring money into its checking account but increase its indebtedness above the debt limit, and from writing checks that would cause it to exceed the amount available to it in its account.

But what happens if the administration ignores the law and writes the checks anyway? It is not clear to me what recourse anyone would have to stop the Federal Reserve Bank of New York from granting the overdraft. Congress could go to court to try and stop it but the judiciary is generally reluctant to intervene in such disputes between the other two branches of government, seeing them as political matters to be resolved in the political arena. After all, Congress always has the power to impeach an administration that defies the laws it passes. But successive administrations have ignored Congressional laws in the past with no repercussions. Right now, the war being waged against Libya seems to be a clear violation of the War Powers Act and yet Congress is mute. It is not clear that violating the Public Debt Act law will cause Congress to do anything other than make a big noise.

Of course, what happens to the US’s credit rating, interest rates, and the value of the dollar if this happens is something else altogether.