Debt crisis: How a US default would have global repercussions
London CNN –
The global economy has been hit by two major shocks within three years. It could be that a third of it comes in the form of a US debt crisis.
After the Covid pandemic and the first major war in Europe since 1945, the specter is haunting that the American government can no longer pay its bills.
For most it is unimaginable, perhaps because the consequences are so terrible. And it might never happen — on Friday there were signs that negotiations in Washington over an increase in the amount of credit the US government can borrow are gaining momentum. If so, however, the 2008 global financial crisis could seem like a walk in the park.
The consequences of a default would be “a million” times worse, said Danny Blanchflower, an economics professor at Dartmouth University and a former Bank of England rate setter. “What happens when the world’s largest economic monolith can’t pay its bills? The consequences are terrible.”
The belief that the American government will pay its creditors on time is the basis for the smooth functioning of the global financial system. It makes the dollar the world’s reserve currency and US Treasuries the bedrock of bond markets around the world.
“Challenging the credibility of the Treasury Department’s obligation to pay can have devastating effects on a number of global markets,” said Maurice Obstfeld, nonresident senior fellow at the Peterson Institute for International Economics, a Washington think tank.
During the 2011 standoff over the US debt ceiling hike, the S&P 500 index of leading US stocks fell more than 15%. The index continued to fall even after an agreement was reached, which happened just hours before the government ran out of funds.
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So far, the stock markets have largely dismissed a possible default, even if the so-called X-date of June 1 is approaching. Then the government could run out of money as it is unable to borrow more, according to Treasury Secretary Janet Yellen, who still expects an agreement to be reached in time.
“One of my concerns is that even before an agreement is reached – if it does happen – there could be significant difficulties in the financial markets,” she said on Wednesday.
Fitch has already put the US credit rating at triple-A, its highest, on a possible downgrade due to political risk.
The move brought back memories of 2011, when S&P downgraded the US from “AAA” to “AA+”. S&P still hasn’t restored that perfect credit rating more than a decade later.
Every downgrade, no matter how small, impacts the pricing of trillions of dollars on US government debt and drives up future borrowing costs. Already, short-term Treasury yields have risen and US mortgage rates have skyrocketed amid uncertainty.
There is no historical precedent for a US default. It is therefore impossible to predict how it would develop and difficult for institutions to prepare for.
This was highlighted in comment this week from the head of one of the world’s largest lenders. World Bank President David Malpass told CNN’s Julia Chatterley that the institution did not have a “dedicated war room” to deal with the threat. “I don’t expect a default,” he added.
There is such a war room at JPMorgan Chase. CEO Jamie Dimon told Bloomberg earlier this month that the bank is holding weekly meetings to prepare for a possible US default and that he expects to meet every day until May 21.
For Carsten Brzeski, global head of macroeconomic research at Dutch bank ING, there can be no “automatic response” to this catastrophe.
In one scenario outlined by Brzeski, the United States could avoid a technical default for a few weeks by continuing to make payments to bondholders at the expense of other budget items, such as spending on Social Security benefits and healthcare. That’s what Moody’s Analytics would call a “violation” of the debt ceiling. A breach is not as serious as a default, which would only occur if the Treasury failed to pay its debt on time.
Markets would still be in turmoil in such a scenario, but it wouldn’t trigger “the mother of all crises,” Brzeski said. However, if a Treasury Department security defaulted, it would trigger “immediate market panic,” noted Peterson Institute’s Obstfeld.
Economists from Moody’s Analytics estimate that even if a breach lasts no more than a week, US gross domestic product (GDP) would fall by 0.7 percentage points and 1.5 million jobs would be lost. In an article this month, they give a security breach a 10% chance, adding that it’s most likely a short-term security breach.
If the political impasse drags on over the summer and the Treasury Department prioritizes debt repayment over other bills, “the blow to the [US] The economy would be disastrous,” they wrote. GDP would collapse by 4.6% and cost 7.8 million jobs. Stock prices would plummet, household wealth would fall by $10 trillion, and the cost of borrowing would soar.
A deep recession in the United States, caused by a prolonged US default or default, would also wreak havoc on the global economy.
In each of these scenarios, if interest rates on US Treasury bonds – which are used to price countless financial products and transactions around the world – rose, the cost of borrowing would skyrocket everywhere. The financial panic would cause credit markets to freeze and stock markets to plummet.
Investors who traditionally buy government bonds in times of crisis could sell them and resort to cash instead. The last time the coronavirus pandemic swept through March 2020, the Federal Reserve had to take extraordinary measures to prevent a full-blown liquidity crisis.
It lowered interest rates, launched a multibillion-dollar bond-buying spree, offered huge cash injections to lenders, and opened lines of credit to foreign central banks to keep dollars flowing through the global financial system.
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The US Treasury Department building in Washington, DC
But the same measures could fail if the US government’s creditworthiness is in question.
“In a Treasury crisis, it’s unclear whether the Fed could do enough even with the efforts it made in March 2020,” Obstfeld said. “It would take a much larger effort to stabilize the market, and that effort may well be only partially successful … or not very successful at all.”
Even more pessimistic is Neel Kashkari, President of the Federal Reserve Bank of Minneapolis. The Fed is “unable to insulate the US economy from the downside of a default,” he told CNN’s Poppy Harlow this week. “A default would send a message to investors around the world that confidence in America is waning,” he added.
Even if confidence in the United States dwindles, the damage to the dollar could be limited. In 2011, the currency appreciated as the shock of the S&P downgrade prompted investors to rush into safe-haven assets like the US dollar.
The currency’s prominent role in the global economy leaves investors with few alternatives in a crisis – even if that crisis originated in the United States.
According to the Fed, between 1999 and 2019, the dollar accounted for 96% of trade settlements in America, 74% in Asia Pacific, and 79% in the rest of the world.
Greenbacks accounted for 60% of disclosed foreign exchange reserves globally as of 2021, with the bulk of that being held in the form of US Treasuries. The dollar is also the dominant currency in international banking.
“The argument for it [the dollar] Is there really no other place to go? It’s not clear where exactly people are going,” said Randy Kroszner, a former Fed governor and now an economics professor at the University of Chicago’s Booth School of Business.
Ultimately, the same argument could help prop up the $24 trillion US Treasury market, which is an order of magnitude larger than any similarly rated Treasury market.
“There simply aren’t enough safe assets available for investors to exit government bonds,” said Josh Lipsky, senior director of the Atlantic Council’s GeoEconomics Center.
But even if the dollar and Treasuries enjoy some protection from their outsized role in international trade and finance, that doesn’t mean the fallout from a US bankruptcy won’t be severe.
“The bottom line,” Lipsky said, “is that if US Treasuries default, even if US Treasuries gain in the short term, everyone — including the US — will still lose.”
— Robert North contributed to the coverage.