A debt default means the US is unable to pay back US bond holders the full value of their bonds. If investors lost money from US Treasuries, it would cause widespread financial panic, leading to a fall in bank lending, rising bond yields, a fall in the value of the dollar and the possibility of a global recession.
There are some things I became reluctant to write on because you can’t believe the situation is so needlessly bad.
Essentially, the Republican dominated congress is attempting to block health care reform by restricting funds to finance it. The President can claim a democratic mandate for health care reform; legislation has been passed and the Supreme Court has ruled it constitutional. By European standards the health care reform is a very modest attempt to extend coverage to the uninsured and try and patch up one of the most inefficient and inequitable health care systems in the world. (see: US v UK health care)
But, for whatever reason, Republicans are blocking the money going to health care, leading to a government shut down. This involves 800,000 federal employees being put on unpaid leave. The fear is that this battle on health care will be a preliminary battle on the debt ceiling.
If congress refuses to allow the debt ceiling to rise, the US may not be able to increase its borrowing. It will be faced with a stark choice.
- Cut public spending immediately by 20% (up to 4% of GDP)
- or face risk not being able to meet debt payments.
In the worst case scenario, the US might find itself unable to meet its debt obligations because Congress is not allowing the Federal Reserve to increase the level of debt. This could mean that holders of US bonds may not have their bonds honoured. If this really did occur, it would cause a widespread panic in the global financial system.
Some believe that it will never come to this as there will be ways to constiutionally wriggle out of the debt ceiling. But, even fears over liquidity shortages could have serious consequences.
What would happen if the US defaulted on debt payments?
- Higher long term bond yields. Any liquidity crisis would cause panic, and other investors would look to offload their US securities. This would increase bond yields and increase the cost of US debt interest payments. The Eurozone has showed how fears over liquidity can be contagious. Even the fear of liquidity shortages can be sufficient to push up long-term bond yields above what they should be. If the US even, temporarily, defaulted, the US is likely to face higher bond yields for a considerable time. This would increase the cost of federal debt interest payments.
- Devaluation in the dollar. If US bonds are seen as risky, foreign investors are very likely to move their funds elsewhere. This would lead to a fall in the value of the dollar as foreign investors sold dollar assets and moved it elsewhere. The devaluation in the dollar would make imports into the US more expensive. The US, a big driver of the world economy, would reduce its demand for foreign exporters. This would hurt economies who rely on strength of US economy. A devaluation in the dollar would also effect other economies who peg their currency to the dollar. They would see a fall in their standards of living and could see inflation.
- Recession. If the US were defaulting, there would be some attempts to panic cut federal spending. The US recovery is fragile and a significant fall in government spending is likely to tip the economy back into recession. Also, the panic and loss of confidence surrounding any potential default would also reduce business investment and consumer confidence. The economic effect of an unprecedented default and cut in aggregate demand could precipitate a deep recession. Another recession would be very damaging for the US and world economy. Unemployment would rise. Ironically, it would also make it harder to deal with debt to GDP ratio as tax revenues would fall.
- Impact on pension and investment funds. Pension funds would be adversely affected by loss of US treasury securities and the resulting financial uncertainty. Pension and investment funds across the world would fall in value.
- Second credit crunch. Many banks use US Treasury bills as collateral against loans. They are considered to be safe enough to lend against. If these no longer are safe, it will affect financial institutions and banks who have invested in US bonds. They will be forced to replace US treasuries with other forms of collateral like cash. It is likely to cause a fall in bank lending as banks can no longer use US Treasuries as a source of reserves.
- Impact on global economy. The dollar is the world’s reserve currency. A US default would cause shock waves across the financial system. US Treasury bills are currently seen as one of safest investments. The global economy would also be affected by a recession in the US and the impact of financial uncertainty. It would be particularly damaging for the Eurozone which is still stuck in recession. The Eurozone has only just managed to reduce bond yields on Eurozone debt. A default in US would bring back fears over a Eurozone default.
It can’t happen can it?
If the US really defaulted the effect on the global economy would be devastating. The irony is that the US budget deficit is falling fast. (Arguably deficit is falling too fast given state of economy). There is no good economic reason not to raise the debt ceiling. But, unfortunately, it seems logic and common sense cannot be guaranteed in US politics.