WASHINGTON (`) – If the debt crisis rocking Washington ultimately plunged the United States into recession, the American economy would hardly go under on its own.
The effects of a first-ever federal debt default would quickly spill over the world. Orders for Chinese factories selling electronics to the US could dry up. Swiss investors who own US government bonds would suffer losses. Sri Lankan companies could no longer use dollars as an alternative to their own shady currency.
“No corner of the world economy will be spared” if the US government defaults and the crisis is not resolved quickly, said Mark Zandi, chief economist at Moody’s Analytics.
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Zandi and two Moody’s colleagues have concluded that even if the debt ceiling were exceeded for just a week, the US economy would weaken so severely and so quickly that about 1.5 million jobs would be lost.
And if a national bankruptcy were to last much longer – well into the summer – the consequences would be far worse, Zandi and his colleagues found in their analysis: US economic growth would fall, 7.8 million American jobs would disappear, lending rates would rise, the unemployment rate would rise to 8% from the current 3.4%, and a stock market crash would wipe out $10 trillion of household wealth.
Of course it may not happen. The White House and House Republicans, seeking a breakthrough, concluded a round of negotiations on the debt ceiling on Sunday and plan to resume talks on Monday. Republicans have threatened to default the government by refusing to raise the legal limit on their borrowing unless President Joe Biden and Democrats accept drastic spending cuts and other concessions.
US debt, long considered extremely safe
Concern is fueled by the fact that so much financial activity depends on confidence that America will always meet its financial obligations. Long considered a safe haven asset, its debt is a foundation of global trade built on decades of trust in the United States. A default could destroy the $24 trillion government bond market, freezing financial markets and triggering an international crisis.
“A debt default would be a catastrophic event with unpredictable but likely dramatic implications for US and global financial markets,” said Eswar Prasad, professor of trade policy at Cornell University and a senior fellow at the Brookings Institution.
The threat has emerged at a time when the global economy is grappling with a multitude of threats – from rising inflation and interest rates, to the ongoing effects of the Russian invasion of Ukraine, to the ever-increasing influence of authoritarian regimes. In addition, many countries have become skeptical about America’s outsized role in global finance.
In the past, American politicians generally managed to jump the abyss and raise the debt limit before it was too late. Congress has raised, revised, or extended the credit limit 78 times since 1960, most recently in 2021.
But the problem has gotten worse. Partisan divisions in Congress have widened while debt has risen after years of rising spending and deep tax cuts. Treasury Secretary Janet Yellen has warned the government could default as early as June 1 if lawmakers don’t raise or suspend the ceiling.
“Shockwaves go through the system”
“If (Treasury’s) trustworthiness were compromised for any reason, it would send shockwaves through the system… and have immense consequences for global growth,” said Maurice Obstfeld, senior fellow at the Peterson Institute for International Economics and former chief economist at the International Monetary Fund .
Treasury bonds are often used as collateral for loans, as a buffer against bank losses, as a haven in times of great uncertainty, and as a place for central banks to park foreign exchange reserves.
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Because of their perceived safety, US government debt — Treasury bills, bonds, and debt securities — has a zero risk weight under international banking regulations. Foreign governments and private investors hold nearly $7.6 trillion of the debt — about 31 percent of government debt in financial markets.
With the dollar becoming the de facto global currency due to its dominance since World War II, it has been relatively easy for the United States to borrow and fund an ever-growing pile of government debt.
But high demand for the dollar also tends to make it more valuable than other currencies, and that comes at a cost: a strong dollar makes American goods more expensive relative to their foreign peers, putting US exporters at a competitive disadvantage. That’s one of the reasons the United States has run a trade deficit every year since 1975.
Central bank dollar holdings
Of all the foreign exchange reserves held by the world’s central banks, the US dollar accounts for 58 percent. No. 2 is the euro: 20 percent. According to the IMF, China’s yuan accounts for less than 3 percent.
Federal Reserve researchers have calculated that from 1999 to 2019, 96 percent of trade in America was settled in US dollars. This also applies to 74 percent of trade in Asia. Outside Europe, where the euro dominates, the dollar accounted for 79 percent of trade.
American currency is so reliable that traders in some unstable economies will ask for payments in dollars rather than their own country’s currency. Think of Sri Lanka, battered by inflation and a staggering decline in the national currency. Earlier this year, shippers refused to release 1,000 containers of much-needed food unless paid for in dollars. Shipments piled up at the Colombo docks because importers were unable to source dollars to pay suppliers.
“Without (dollars) we cannot transact,” said Nihal Seneviratne, a spokesman for the Essential Food Importers and Traders Association. “When we import, we have to use hard currency – mostly the US dollar.”
Likewise, many shops and restaurants in Lebanon, where inflation is raging and the currency has plummeted, require payments in dollars. In 2000, Ecuador responded to an economic crisis by replacing its own currency, the sucre, with dollars – a process called “dollarization” – and has stuck with it.
The contact point for investors
Even when a crisis originates in the United States, the dollar is invariably the safe haven for investors. This is what happened in late 2008, when the collapse of the US housing market bankrupted hundreds of banks and financial firms, including the once-mighty Lehman Brothers: the dollar soared.
“Even though we were the problem — us, the United States — there was still a flight to quality,” said Clay Lowery, who leads research at the Institute of International Finance, a banking trading group. ‘The dollar is king.’
If the United States went beyond the debt limit without resolving the dispute and the Treasury Department defaulted on its payments, Zandi suspects the dollar would, at least initially, rise again “because of the uncertainty and fear.” Global investors would just do it. “I don’t know where to go, except where they always go when there’s a crisis, and that’s the United States.”
But the Treasury market would likely be paralyzed. Instead, investors could shift their money into US money market funds or the bonds of top-rated US corporations. Ultimately, Zandi says, growing doubts would erode the dollar’s value and keep it low.
Government strategy when exceeding the debt ceiling
Lowery, who was Deputy Treasury Secretary during the 2008 crisis, believes the United States would continue making interest payments to bondholders in a debt crisis. And it would seek to pay its other obligations — to contractors and retirees, for example — in the order in which those bills fall due and as soon as money becomes available.
For example, for bills due on June 3rd, the government could pay on June 5th. Some relief would occur around June 15th. Then government revenue would flow as many taxpayers make estimated tax payments for the second quarter.
The government would likely be sued by those who didn’t get money — “anyone who’s living on Veterans’ Benefits or Social Security,” Lowery said. And rating agencies would likely downgrade the US debt even if the Treasury continued to pay interest to bondholders.
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Although still dominant globally, the dollar has lost some ground in recent years as more banks, businesses and investors have turned to the euro and, to a lesser extent, the Chinese yuan. Other countries tend to fret that fluctuations in the value of the dollar can harm their own currencies and economies.
A rising dollar can trigger crises abroad by diverting investment from other countries and increasing their cost of repaying dollar-denominated loans. The United States’ eagerness to use the dollar’s power to impose financial sanctions on rivals and adversaries is also viewed with concern by some other countries.
So far, however, no clear alternatives have emerged. The euro lags far behind the dollar. This applies even more to the Chinese yuan; It is paralyzed by Beijing’s refusal to let its currency trade freely in world markets.
But the debt ceiling drama is sure to raise questions about the vast financial power of the United States and the dollar.
“The global economy is currently in a rather fragile situation,” said Obstfeld. “So it’s incredibly irresponsible to throw another US debt credit crisis into this mix.”
` writer Bharatha Mallawarachi, from Colombo, Sri Lanka, contributed to this report.
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