The Default Debate : Treasury, Fed Differed on How to Plan for the ‘Unthinkable’

It was last summer, as Republicans sought to confront President Clinton over the budget, that a group of top U.S. officials began to ponder the unthinkable: a meltdown of the financial system, sparked by an unprecedented default of the U.S. Treasury.

To the amazement of many, GOP hard-liners in the House seemed willing to risk such an event if the nation’s debt limit wasn’t raised on their own terms; at least some talked as if they were.

But as attention focused on the escalating budget fight in Congress, a separate struggle involving Treasury Secretary Robert E. Rubin, Federal Reserve Board Chairman Alan Greenspan and other high-level officials was unfolding far from the spotlight.

The issue: whether the Fed should prepare for the financial debacle of a default--however unlikely--just as emergency officials prepare for an unexpected nuclear attack or a natural catastrophe that may never occur.

On one side, Rubin and his top lieutenants at Treasury feared that even a mere planning exercise would lend credence to the unthinkable idea and panic Wall Street if word leaked out. For their part, several Federal Reserve governors argued that it would be grossly irresponsible not to explore contingency plans.

Ultimately, around late September, Rubin was prevailed upon to allow the secret planning exercise, apparently accepting the Fed governors’ arguments that there was little choice, given the continuing confrontation with Congress and its uncertain outcome, knowledgeable sources told The Times.

“You make the atom bomb. You say the government will never use the atom bomb. But then it falls into the hands of terrorists,” said one official, alluding to fears that Congress might blunder into a default rather than cause one on purpose.

It will remain a mystery whether such a default could have sparked the worst-case scenario: a chain reaction paralyzing credit markets and even ordinary check-cashing operations, pushing up interest rates and disrupting the banking system.

And now that President Clinton has signed into law a bill raising the nation’s $4.9-trillion debt limit, the matter has faded from the news, like an obscure conflict over arcane issues in an unknown corner of the globe.

Yet to a small circle of officials at the highest levels of economic policymaking, the episode endures as a troubling instance of political forces menacing the gigantic, $6.8-trillion U.S. economy.

Details disclosed only now offer a peek into a closed community of government financial officials who were pulled by conflicting currents as the debt flap unfolded. Neither the Fed nor the Treasury Department would comment for this story, and only sketchy details are known even today of the quiet and unreported tug-of-war between the nation’s premier financial authorities.

*

However, certain previously undisclosed information has trickled out from sources close to the situation--details that underscore the painful political nerves that the debt-limit debate touched on.

As knowledgeable sources tell it, Greenspan seemed reluctant to challenge the Treasury over its handling of the issue, remaining keenly aware of the partisan nature of the larger budget fight and the Fed’s official neutrality. Some of Greenspan’s associates bridled, meanwhile, as time passed and Treasury did not approve the laying out of contingency plans.

Ultimately, the whole affair came to dramatize the need for a simple, long-term solution, some experts concluded: Dump the debt limit altogether.

“At some time in the future, when the heat of the current battle is past, we ought to quietly get rid of this thing,” maintains William Poole, an economist at Brown University.

Throughout the controversy, debate was taking place on two tiers. On the public level, it focused on interest rates. That is because in a default--in which the Treasury is unable to meet its financial promises on time--investors would demand higher rates on Treasury securities that would no longer seem so rock-solid. The result: a costlier debt burden for U.S. taxpayers.

But behind the scenes, many officials worried about a more immediate problem: that a default might create a tidal wave of chaos, leaving banks unable to cash checks, many large corporations unable to meet their payrolls and a multitude of other borrowers in limbo.

A “payments” crunch could mean countless benefits withheld from average Americans holding government checks. The fallout would threaten other areas, as well, if banks, money markets and corporations were suddenly left holding large volumes of Treasury securities that had uncertain value.

“Believe me, there would be an earthquake,” said David M. Jones, chief economist at New York investment firm Aubrey G. Lanston & Co.

In many ways, however, the event would be electronic, unfolding along an intricate web of data pathways linking the Federal Reserve, major banks and investment firms on Wall Street. Experts sometimes refer to this obscure financial architecture as “the plumbing.”

If a default occurred, say, on Nov. 15, what would be the value of an unredeemed Treasury security that had come due on Nov. 14? What would be the status of existing government checks? What were officials supposed to do to which computers--and when--to keep disruptions to a minimum?

These were the sorts of questions that Fed officials were eager to explore.

Given all these high-stakes uncertainties, “it would just be crazy” to allow a default, said Rudolph G. Penner, a former director of the Congressional Budget Office and managing director of KPMG Peat Marwick’s Barents Group economics firm in Washington.

Nevertheless, jitters began to mount last year, as the national debt approached the legal ceiling of $4.9 trillion, and conservative Republicans perceived an opportunity. Hard-liners vowed to load up the needed debt-limit hike with GOP provisos on the budget; Clinton, they figured, would not dare veto an increase.

Yet as Democrats and Republicans played out their noisy battle in public, the separate conflict smoldered among the government’s top financial authorities.

Nobody really expected a default. All along, government officials viewed the tough, Republican rhetoric more as bravado than a sign of the members’ true intent. Any hint that the government was bracing for a default, Treasury officials maintained, only would confer an aura of reality on the outlandish scenario. Shock waves might then wash over Wall Street and the whole economy.

By summer, however, a different view was emerging inside the Fed. Increasingly, some insiders concluded it would be negligent not to explore contingency plans, even if a default seemed the longest of long shots. The analogy was to emergency management or disaster preparation. At the very least, the government should be prepared. Meetings were held. The Fed-Treasury impasse went on.

Greenspan was described as reluctant to do anything that could be interpreted as taking sides. The Fed, after all, was supposed to conduct the nation’s monetary policy independently of the political hurly-burly. As time passed, however, and other officials pushed for a Fed role, the Republican chairman gradually leaned more their way.

Beyond the partisan difficulties, the past also cast a shadow on the dispute.

*

Over the years, the Fed and Treasury have clashed periodically over issues of Fed independence. In contrast to its autonomous mission of setting interest rates, the Fed is the Treasury’s junior partner--its “fiscal agent”--in certain other matters. Key preparations for a default were among them.

Last summer, as Rubin resisted the Fed’s request to conduct its pre-default planning maneuvers, some of the central bank’s officials grew increasingly frustrated.

“The Fed has an institutional interest in making sure the plumbing will continue to work,” noted Donald F. Kettle, a political scientist at the University of Wisconsin. “It’s their basin [that] the sewer would have backed up into.”

Worries focused increasingly on an out-of-control political process in which hard-line Republican freshmen failed to follow the directives of their leadership. Was it just possible that the Treasury might run out of room to borrow and that GOP leaders could not muster the votes to stave off the unthinkable?

The risk, while unlikely, seemed to be rising because of the volatile political debate in Congress over the budget and the confrontational stance urged by hard-liners.

As one official put it: “Miscommunication. Pique. A plane doesn’t land on time.” Such twists of fate might raise the chances that a vote could go the wrong way, leading to an unplanned debacle.

In early autumn, Rubin finally gave the Fed the green light to begin contingency planning, accepting the argument that it would be irresponsible to impede such an exercise. Technical experts at the New York Federal Reserve Bank and elsewhere in the sprawling Fed system quickly launched their exercise, under special orders to keep mum and limit outside involvement.

Even now, those who know of the effort decline to disclose much about the planning, which focused in large measure on technical issues involving computer programs and software.

And the lessons learned were cautionary: Sources told The Times that technical adjustments to the plumbing might be sufficient to keep the financial payment system from collapsing although the task would be a “messy” challenge.

As it turns out, of course, the effort remained only a dress rehearsal. Rubin found ways to maneuver beyond the debt ceiling for several months and avert default even without congressional approval. Passage of a new debt limit has defused the matter.

*

Yet for all that, a growing number of economists call for a different sort of antidote: The debt ceiling, they maintain, should simply be tossed out.

They say that the cap, intended as a check on endless federal borrowing, has instead become an invitation to political mischief. Proposals for spending and taxes ought to be evaluated on their merits, goes the thinking, rather than get tangled up in periodic controversies over an over-arching debt limit.

Otherwise, they warn, Congress and the White House are destined to play future games of chicken over default, with all the risks that such collisions entail.

“It confuses the debate,” said Poole, the Brown University economist. “It serves no economic function. It does not change by one nickel the amount of debt held by the public. . . . The logical thing is simply to do away with it.”

Rising Tide

Since 1980, the national debt has risen from slightly more than $900 billion to nearly $5 trillion, an increase of 441%. The federal government has not posted a surplus since 1969.

Sources: Dept. of Commerce, Dept. of the Treasury, Office of Management and Budget