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?

1. 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.
2. 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.
3. 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.

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I’m currently writing a 2,500 word essay on ‘UK Austerity’ for the magazine Economic Review. I think the idea of these magazine articles is to present a ‘balanced view’ so I’ve been looking up the case for austerity as well as the case against. As far as I can see the economic rationale for austerity includes some or all of the following:

1. Rising bond yields. Starting with Greece, several Eurozone economies faced sharply rising bond yields in the period 2009-12. Investors were no longer confident in the ability of European countries to repay government debt or at least stay liquid. Therefore, they demanded higher bond yields in compensation for the increased perceived risk.

Rising bond yields were taken as a sign that debt levels were too high and unsustainable. Therefore, to reassure bond markets, governments pursued austerity / spending cuts to reduce budget deficits and hopefully reduce bond yields.

In the case of the UK, the government argued that if Greece, Ireland and Italy could all have rising bond yields, the same could happen to UK bonds. If government bond yields did rise, the government argued it would have many adverse consequences for the economy:

• Increase cost of debt interest payments.
• Make it difficult to sell sufficient bonds to cover the large budget deficit.
• Rising bond yields can create a knock on panic to other bond investors. The nervousness was potentially contagious.

2. Crowding in.  There is a view that if the government reduces spending and reduces government borrowing, then this enables a growth in the private sector. The argument is that government borrowing restricts private sector investment because when the government borrows it takes money which could be used to finance private sector investment.

3. ‘Expansionary austerity’ This was a view offered at the start of the crisis. The argument is that uncertainty over rising bond yields was holding back private sector investment. If the government pursued austerity and proved to the market it was serious about reducing the deficit and bond yields, markets would be more confident about the future. The sound money of the government would encourage private sector investment and higher economic growth.

4. State is too big. Mixed up in the case for austerity is the more general argument that state spending had got too big. The recession was seen as a good time to cut away inefficient government spending. In particular, some economists were critical of the bloated size of the welfare state and pension commitments.  Often critics of Keynesian economics argue that if you pursue temporary spending to boost demand, this temporary stimulus ends up being permanent, due to special interest groups. Instead, the opposite should occur, and governments should take the opportunity to cut spending.

5. Debt is too high. The credit crunch was caused by banks taking on too many ‘bad’ debts. Because the excess accumulation of  private sector debt caused the credit crunch and recession, it was easy for governments to make a link that we need to tighten belts and reduce government debt burdens.

EU debt levels debt / GDP % 2007 – 2010

e.g. Ireland debt to GDP ratio rose from 27% to 97% between 2007 and 2010

In the great recession, budget deficits did rise rapidly because of the  fall in tax revenues due to recession, rise in welfare spending due to unemployment, and bailing out banks.

One influential paper (2010) by Carmen Reinhart, now a professor at Harvard Kennedy School, and Kenneth Rogoff, an economist at Harvard University, suggested that when debt / GDP  levels rose above 90%, then it leads to significantly lower economic growth. (90% question at Economist) Therefore, this provided an argument for tackling government debt.

6. Countries with austerity have had positive growth

Every country which pursues austerity has at some time seen economic recovery. Latvia experienced a strong recovery (after very sharp fall in GDP during the recession.) Now positive growth in UK is seen as vindication of austerity.

Criticism of Austerity

A quick evaluation to these points

1. Rising bond yields. The assumption was that rising bond yields were due to high levels of debt. But, with perhaps the exception of Greece, rising bond yields were primarily due to having no Central Bank willing to act as lender of last resort. Evidence for this comes from:

• Countries like US and UK with very large budget deficits saw falling bond yields during the recession. These countries had own currency and Central Bank willing to ensure liquidity.
• In 2012, when the ECB finally became willing to buy unlimited bonds, bond yields fell sharply.
• Austerity policies often caused bond yields to rise because markets feared falling GDP would make debt levels more unmanageable.

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