The Elusive Assessment of US Sovereign Risk

The US Treasury is the world&s;s largest and most systemically important debtor. Although this debt had long been assumed to be risk-free, a series of debt ceiling showdowns and credit rating agency actions have called this assumption into question. The purpose of this chapter is to discuss scenarios under which the US government might default on Treasury securities and how likely these scenarios are to occur over the coming years. One scenario involves a Congressional failure to increase or suspend the federal debt ceiling in a timely manner, preventing the US Treasury from borrowing funds to make timely interest and principal payments on outstanding securities. This situation occurred in 1979, but the payment failure was brief and little noticed. A second scenario would involve the Federal Reserve refusing to finance new debt issuance or debt service. This could happen if the Chair and Governors determine that creating new reserves to fund Treasury operations would trigger unacceptable levels of price inflation. For this scenario to occur, debt issuance would have to reach a point at which monetizing it would be highly inflationary. Determining whether this might occur requires estimates of future debt issuance and the ability and willingness of market participants other than the Federal Reserve to take up this debt. Finally, any debt that the Fed would be obliged to monetize must be compared to the existing stock of monetary reserves. The degree of Federal Reserve independence must also be considered. Although the Fed is technically independent, its Board Members are appointed by the President of the United States and confirmed by the Senate. Fear of not being reappointed or being removed (a presidential prerogative that has not been established) may cause the Chair to accommodate the government&s;s financing requirements even if they are inflationary.