It seemed unthinkable to many, but in July of 2011, the possibility that the US federal government would default on its debt was becoming an increasing likelihood. The problem was not insolvency; rather the Congress was refusing to increase the debt limit of the country. Without Congressional action, the Treasury Department would not be able to issue more debt, and in turn, pay off coming obligations and the interest on the current debt.
For Ben Bernanke, the Chair of the Federal Reserve System, breaching the debt limit was concerning. As the Treasury’s fiscal agent, Bernanke and the Fed would advise the Treasury on how to pay its obligations. Observers conceded that both available options would disrupt the economy, but which option was the least bad?
No matter how the Treasury chose to pay its obligations, the Fed’s charge to regulate large money center banks and maintain stability in the financial markets would be put to a test. A Treasury default would mean that there would be large movements of cash and changes in perceptions of risk that could alter key financial ratios used to oversee bank operations. What guidelines should the Fed issue? To maintain financial stability, the Fed had a number of mechanisms at its disposal. Many of these related to existing desk operations that the Fed used to implement monetary policy, such as the sale and purchase of securities. But how should these be altered to deal with the influx of Treasury securities in default? The Fed staff also had prepared a number of novel courses of action that would help reduce strain and introduce increased liquidity. Should the Fed put these extraordinary measures into place?
When choosing among the options, Bernanke and the Federal Open Market Committee had to consider a number of competing factors. Arguing for minimal action, the Fed wanted to maintain its independence from the country’s political institutions and therefore not interfere in the battle between the Congress and the Administration. On the other hand, the Fed was responsible for the smooth functioning of the financial system and for fostering its dual goals of maximum employment and stable prices.
Publication Date: 2019-09-10
Suggested Citation: William B English and Jaan Elias, "2011 Debt Limit Crisis: How Should the Fed Respond?" Yale SOM Case 19-016, September 10, 2019.
Keywords: Federal Reserve, Treasury Department, Monetary Policy, Federal Open Markets Committee, Fiscal Agent, Tea Party, Repo, Money Market Mutual Funds
Teaching Note: No