By Randy Cohen, PhD., Cofounder PEO Partners. PEO Partners is a leader in the emerging liquid Private Equity alternatives space. PEO developed a proprietary investment model to deliver performance comparable to average LBO performance net of fees in the public markets.
Was the Federal Reserve Holding the Debt Ceiling Cards All Along?
You were wondering how Biden was able to get such a good deal; in the end all this drama just amounted to getting the budget-negotiation process started early, with the GOP’s main takeaway being something (spending freeze) that their control of the House already guaranteed them via the tool of passing continuing resolutions.
Joe did a far better job than anyone imagined he could, for about the 79th time in a row. But that said, the key thing to recognize is that Biden’s hand was much stronger than anyone I read seemed to understand. What the media got right is, if a default destroyed the economy, that would hurt Joe/Dems in the general; even if people in some sense knew it was the GOP’s fault, they’d still mostly follow the heuristic “if things are going well, I’ll vote for the incumbent; if not, throw the bums out!”
But consider this: what if a default isn’t devastating for the economy? And what if Joe and Kevin both know it? Well in that case, default is fine for Biden, because he can then blame whatever economic difficulties occur between now and Election Day on the GOP-created default! Of course not all such blame will stick, but the point is, if the default doesn’t meaningfully damage the economy, then it’s a net positive for Joe’s re-election chances, because it means he’ll get at-least-a-little-bit reduced blame for whatever bad things (recession, slow wage growth, inflation, etc.) were going to happen anyway.
Presumably at this point you’re thinking, “sure, in that hypothetical Joe’s hand is strong, but we all know that a default would be a catastrophe surrounded by a disaster, wrapped in a calamity.” But do we? Take a look at the stock market — was it falling in fear of a crash as the deadline loomed? Not so much! Even better, look at the volatility index, or VIX, where investors can speculate on the probability that things get riskier. It’s near the lowest level since before the pandemic. The press focused on the fact that short-term Treasury bills reflected a significant default probability, but this is, in combination with the quiescent stock market and VIX levels, comforting news. It suggests we’re not in the situation that default would be catastrophic but it’s unlikely. Rather, it says, sure, default might happen, but it won’t croak the market. Because if default is reasonably likely, as the T-Bill rates suggest, and default would croak the market, then we’d have seen stocks drop and implied volatility rise. Since we didn’t see those things, it suggests the market thought default wouldn’t be a huge issue.
Now, by itself that’s not enough; financial markets aren’t always right. Though surely the disconnect between the panic in the press and the total calm of the markets was worthy of a great deal more investigation than it received. Journalists should have been asking themselves, “what do the markets know, or think they know, that we don’t?” Here’s a likely answer: if all else fails, the Fed can solve the default problem, and they don’t need a platinum coin to do it. All the Fed needs to do is… buy the defaulted bonds!
I know this seems so sinple as to be almost silly, but remember, buying bonds is something the Fed does on a regular basis; such activity is commonly referred to as “quantitative easing” or QE. It’s just absolutely normal for the Fed to make bond purchases. Of course traditionally QE meant buying the world’s safest assets, which is to say, rock-solid US Treasury bonds. Whereas defaulted Treasury bonds are somewhat riskier. But not all that much riskier, after all, everyone knows this debt limit thing will eventually get resolved. And ever since TARP and all the other activities surrounding 2008 and it’s aftermath, it’s become quite normal for the Fed to buy risky bonds, corporate bonds and the like; the TA in TARP stood for Troubled Assets. Recall also that the Powell Fed committed to buy risky corporates during covid. It just wouldn’t be weird at all for the Fed to say: If you have a $1000 bond maturing June 15 and the Treasury doesn’t pay it, we’ll buy it from you for face value. The same with coupons.
In truth the Fed might well get fancier and just commit to lend the face value of bonds to people, collateralized by defaulted Treasuries. There’s no doubt this is legal because this is exactly what the Fed did during the recent regional-bank bailouts. Indeed a cynic might say they did it precisely so that no one could say, come June, that such an action is novel or legally sketchy — it literally just occurred a month or two ago and no one had any problem with it. I think the engineers call this a “smoke test.”
Now of course no one knows what the Fed would do in a default scenario. Certainly Joe would not actually prefer to default and find out. But that said, I mean, can we really imagine Jerome Powell letting the global financial system collapse on his watch when he could easily address the problem employing tools he’s been using regularly since he took office? Almost for sure he would step up. The uncertainty is large enough to bring Joe to the negotiating table, but the near-certainty the Fed would save the day means Joe was holding aces. He could say to McCarthy: look, I’m boring old Joe, so you know I’m not hoping for default. But if it happens, it’ll help me a bit in the general with 98% probability, and that’s sufficient to keep me from giving it all away in this negotiation. Rather, I’ll give you just enough so you can tell your supporters you won, and bring a reasonable fraction of the GOP House caucus. I’ll deliver the rest of the votes, and we’ll get back to business as usual.”
Although this email has been long by 2023 standards, recognize that it’s hugely oversimplified. The Fed bond purchases of loans do not, on their own, fully solve the problem; the Administration would need to take additional steps as well. But it would solve the bulk of the problem, and other needed steps are well understood; e.g. continuing “extraordinary measures,” issuing Treasuries to pay Social Security and Medicare under the 1996 law that allows borrowing above the debt limit for this purpose, and so forth.
The Administration had access to a layered defense which includes paying the bonds while shutting down the government as a stopgap, just paying everything and saying he had to choose between breaking one law or another and chose the less damaging option, and other approaches, with the Fed as a final backstop. But the Fed’s potential role is, I think, the key element left out of most discourse. Understandably the Fed wants the President and Congress to work this out so will swear up and down until the last minute that they cannot help. But this is obviously untrue; in fact the WSJ had a piece that glancingly mentioned how the Fed wargamed this scenario back in, IIRC, 2014. It’s an option, and security prices suggest Wall Street knows it, which means Biden and McCarthy know it.
And that, plus Joe Biden being a talented people person who’s been getting deals done in Washington for half a century, is good at it and knows he’s good at it, will, assuming this deal passes Congress, be the reason he once more made fools of all the doubters.
About the Author:
Randy Cohen is the MBA Class of 1975 Senior Lecturer of Entrepreneurial Management at Harvard Business School. Cohen teaches finance and entrepreneurship at HBS and has previously held positions as Associate Professor at HBS and Visiting Associate Professor at MIT Sloan. He currently teaches Field X/Y at HBS, a course for students who are starting businesses while obtaining their MBA. Last year he advised around 90 startup businesses in the course. He co-developed the Alternative Investments course for HBS Online which will go live in the first quarter of 2020. Mr. Cohen’s main research interests are the identification and selection of money managers who are most likely to outperform, asset allocation, risk management, and anything else related to building great investment portfolios. Cohen has studied the differential reactions of institutions and individuals to news about firms and the economy, as well as the effect of institutional trading on stock prices. Other research areas include activist investing, municipal securities, cryptocurrency, and longevity insurance. In addition to his academic work, Cohen has helped to start and grow a number of businesses, mostly, but not exclusively, in the area of investment management. He also has served as a consultant to many established money management firms. Cohen holds an AB in mathematics from Harvard College and a PhD in finance and Economics from the University of Chicago.
