By Paula Dwyer

If Congress fails to lift the debt ceiling by Aug. 2, can the Federal Reserve do anything to help the U.S. government avoid defaulting on its bills?

Joseph E. Gagnon, a former Fed economist who is now a senior fellow at the Peterson Institute for International Economics, thinks it can -- and that the answer is at Fort Knox.

The Treasury keeps 5,000-plus tons of gold, mostly at the U.S. Bullion Repository, as Fort Knox is formally known. The gold is carried on the government's books at about $11 billion. But the gold's market value, at more than $1,600 an ounce, is about $418 billion. The $407 billion difference is enough to cover the government's deficit for three months.

The solution, Gagnon says, is to monetize the gold at market prices. Here's how it could work: The Fed owns certificates, backed by U.S. gold reserves, priced at $42 an ounce. Treasury can exercise an option it has to buy the certificates back at that price, for a total of $11 billion. The next step, which would require Fed Chairman Ben S. Bernanke's cooperation, would involve Treasury selling the gold certificates back to the Fed at close to market price, netting taxpayers about $407 billion.

The Fed would be stuck holding a risky asset that pays no interest. To fix this, the Treasury and the Fed could enter into a gentleman's agreement in which Treasury gives the Fed an option to sell the gold certificates back to Treasury at the same price -- or they could build in a small profit for the Fed -- once the debt ceiling is lifted and Treasury can resume bond auctions.

All of this could take place as an accounting transaction, and wouldn't move the price of gold or require physically moving bullion from the Fort Knox vaults. Treasury Secretary Timothy Geithner has said he doesn't want to sell off U.S. assets like gold reserves, especially if he has to sell at fire-sale prices. Gold sales might also trigger a populist backlash. This transaction would avoid both scenarios. "When all you have is bad choices," Gagnon says, a Fed-Treasury gentleman's agreement looks a lot more attractive.

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-0- Jul/29/2011 22:08 GMT