Colin Barr

Following the money in banking, economics, and Washington

The Fed's scary doomsday drill

July 20, 2011: 5:05 PM ET

Hoping Aug. 2 will come and go uneventfully? Read Wednesday's comments from Philadelphia Fed President Charles Plosser and weep.

Plosser (right) says the Federal Reserve is gearing up for a possible U.S. default should the loons in Congress fail to raise the debt ceiling. He stresses in an interview with Reuters that he isn't predicting this baleful outcome, but he doesn't underplay how quickly a default might spin out of control.

Opposes blowing up the economy

The Fed, after all, is the government's clearing bank. The process of deciding which checks to honor and which to bounce sounds a bit daunting, considering the scale of the government's checkbook – even as Plosser claims it is all going to be "manageable."

"How the Fed is going to go about clearing government checks. Which ones are going to be good? Which ones are not going to be good?"

There is also the question of whether the Fed, or anyone else for that matter, will continue treating Treasury debt as acceptable as collateral for loans backing all manner of things – Fed loans, brokerage accounts, you name it.

"Do we treat them as if they didn't default, in which case we would be saying we are pretending it never happened? Or do we treat them as if they defaulted and don't lend against them? Those are more policy questions."

Pretending stuff never happened does have a proud history in policy circles, but these are more than policy questions. The discussion at the Fed – which Plosser soft-pedals as mere "contingency planning" – highlights the possibility, however slim, that financial markets could utterly break down, and take the economy down with them, as lenders decide to shun government bonds as collateral till the U.S. budget debacle is cleared up. That means no lending, more or less.

The credit crunch after the Lehman Brothers bankruptcy would seem like a fond memory after the economic plunge that would follow a mass rejection of Treasury debt as collateral.

Those are among the "catastrophic" effects Ben Bernanke has noted now and again, and if Plosser doesn't go quite that far he doesn't exactly do anything to put the mind at ease, either.

"It could be very bad. At some level we don't really know what the consequences could be. It could be very serious. It could be less serious. Do we really want to run that experiment?"

I personally don't, but someone might as well ask John Boehner just to make sure.

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Colin Barr
Colin Barr
Senior Writer, Fortune

Colin Barr has covered finance for Fortune.com since November 2007. Previously he was a writer and editor for TheStreet.com, winning a 2006 Society of American Business Editors and Writers award for "The Five Dumbest Things on Wall Street," and for Dow Jones Newswires. He is a 1991 graduate of Penn State and lives in Port Washington, N.Y., with his wife Meena Bose and their two kids.

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