How Would a Government Default Affect Real People? Thank Heavens for the Fed!

-- Posted by Neil H. Buchanan

As we approach the drop-dead date on the debt ceiling, most of the worry has revolved around the effects on financial markets, and then on the broader economy through the contractionary effects of reduced government spending and collapsing confidence. Paul Krugman catches the vibe with a short blog post appropriately titled "Hitting the Ceiling: Disastrous or Utterly Disastrous?" in which he summarizes a research memo from Goldman Sachs that predicts a deep recession, even if there is not a complete collapse of the financial markets.

Again, however, the notion of a financial market collapse can seem rather abstract.  What does it mean for you and me, if the stock and bond markets go into a swoon?  Sure, everyone who invests in those markets (directly or indirectly) would suffer paper losses, with their various retirement accounts and investment portfolios dropping in value.  But what if you are not invested in those markets (at all, or at least not much), and you are simply one of the people for whom relying on "the financial system" boils down to withdrawing money from ATM's, paying bills with checks or online payments, and so on?

One of my former students posed that question this way: "I keep hearing how devastating a government default would be for the economy.  I'm just wondering if it's safe to keep my money in a bank.  I hope this doesn't get that far, of course, but I still have to have access to money to pay things like rent.  Could a government default have that kind of an impact on individual savings and checking accounts?"

I confess that my first thought upon reading those questions was to smile wryly and think, "Boy, we don't teach law students enough basic economics!"  I honestly cannot say, however, that the typical college graduate who majored in economics or finance could answer those questions competently.  In fact, I am not sure that anyone (including me) can answer them with any degree of confidence, because we are now facing a potential disaster the likes of which we have never faced before (man-made or otherwise) -- precisely because no one has ever before thought that it would be a good idea to threaten the global economy with collapse in order to deny people health care (or whatever the current excuse is).  Even so, we can say a few things with some confidence, which lead to a simple piece of advice: Sit tight, and leave your money where it is.

The most basic question that my former student is asking is whether money that he has deposited in financial institutions will still be accessible in the wake of a government default and financial market panic.  The bad news is that individual depositors cannot count on the FDIC to cover their deposits.  Why?  Not because it is a government agency that could be subject to shutdown (if it has not already been shut down -- I have not checked), but because it is an insurance system.  Insurance systems are like fire departments, that is, they are not designed for widespread conflagrations.  If one or two houses in a town catch fire on a given night, or if one or two financial institutions need liquidity due to unexpected problems, the fire department and the FDIC are there for us.  If the whole world is in flames, the whole story changes.

That is not to say that the FDIC would not continue to be the face of any government protection of depositors, but that it would have to be backed by something much more powerful.  That would be the Federal Reserve.  Even if the President chooses to allow default (ignoring the entreaties from Professor Dorf and me to honor all obligations by issuing additional debt, if push comes to shove), the Fed can and will do everything it can to shore up the financial system, most especially including guaranteeing the continued operation of the basic payments systems and the depository institutions on which the real economy relies.

For all of the criticism heaped on the Fed and Treasury after the 2008 financial crisis for bailing out big banks, their performance at that time was exemplary.  Fortunately, Ben Bernanke is still the chair of the Fed, and he has made it clear that he will put as much money into the banking system as necessary to prevent collapse.  Although we have never faced this kind of threat to the economic system before now, the 2008 near-panic was a rather good dress rehearsal.  After the bailout, the politicians failed to make the banks bear enough of the costs, but that does not mean that the bailout was a bad idea.

Again, it was really the Fed that saved the day.  The now-reviled TARP (Troubled Assets Relief Program) was essential (and the Obama Treasury shows every sign of being willing and able to administer something similar, if necessary), but the $700 billion or so involved in TARP were nothing compared to the trillions that Bernanke used to prop up the global economic system.  You can say all you want that the money was created "out of thin air," but the fact is that finance is all (by definition) unreal assets, and the strategic manipulation of unreality is what central banking is all about.

Five years ago today, many people were seriously wondering, for very good reason, whether the whole economic system was in the process of collapsing.  That "We're all gonna die!" moment passed, almost entirely because of the Fed (with best supporting actor awards shared by the Bush Treasury and the members of Congress who voted for TARP).  Congress has become crazier, but the Fed is still there.

Of course, it is still possible that the next crisis will be too big for even the Fed to stop.  If that becomes true, however, we will have much bigger problems than being able to pay rent in a timely way.  The people who want to be fully prepared for the absolute worst have already been buying gold from Glenn Beck for the last five years, and storing food and ammunition in refurbished nuclear fallout shelters.  For the rest of us, a truly complete panic in the financial system will lead to very bad outcomes.  But there is really nothing to do but, as Londoners used to say, keep calm and carry on.