A US debt default would reverberate around the world

Londres (News) — The world economy has suffered two major shocks in three years. It could be about to suffer a third because of the US debt crisis.

Following the covid pandemic and the first major war in Europe since 1945, the specter of the US government’s inability to pay its bills now haunts financial markets.

For most, it is unthinkable, perhaps because the consequences are terrifying. And it may never happen: There were signs this Friday that negotiations in Washington to increase the amount the US government can borrow were gaining momentum. But if it does happen, the global financial crisis of 2008 might seem like nothing.

The consequences of a default would be “a million” times worse, said Danny Blanchflower, a Dartmouth University economics professor and former head of interest rate setting at the Bank of England. “What happens if the world’s biggest economic monolith can’t pay its bills? The consequences are terrifying.”

The belief that the US government will pay its creditors on time underpins the smooth functioning of the global financial system. It makes the dollar the world’s reserve currency and US Treasuries the foundation of bond markets around the world.

“If the credibility of Treasury’s payment commitment is called into question, it can wreak havoc in a whole host of world markets,” said Maurice Obstfeld, a nonresident fellow at the Peterson Institute for International Economics, a Washington think tank.

During the 2011 standoff over raising the US debt ceiling, the S&P 500 index of major US stocks plunged more than 15%. The index continued to fall even after a deal was reached, which came just hours before the government ran out of funds.

Stock markets have so far dismissed a possible default, even as the so-called X-date of June 1 approaches. That’s when the government, unable to borrow more, could run out of money, according to Treasury Secretary Janet Yellen, who continues to believe a deal will be reached in time.

“One of the concerns that I have is that even in the run-up to a deal, when it does happen, there may be substantial distress in the financial markets,” he said on Wednesday.

Fitch has already put the US’s triple-A credit rating, its highest score, on watch for a possible downgrade due to risky policies.

The move brought back memories of 2011, when S&P downgraded the US rating from “AAA” to “AA+.” More than a decade later, S&P has still not reestablished that perfect credit rating.

Any downgrade, no matter how small, affects the price of trillions of dollars of US government debt and causes future borrowing costs to rise. Short-term Treasury yields have already risen and US mortgage rates have soared amid uncertainty.

From bad to worse

There is no historical precedent for a default in the US, making it impossible to predict how it would play out and making it difficult for institutions to prepare.

This was revealed this week by the director of one of the largest lenders in the world. World Bank President David Malpass told News’s Julia Chatterley that the institution did not have a “special war room” to manage the threat. “I don’t expect a default,” she added.

That “war room” does exist at JPMorgan Chase. Its CEO, Jamie Dimon, told Bloomberg earlier this month that the bank was holding weekly meetings to prepare for a possible US default and expected to meet every day by May 21.

For Carsten Brzeski, global head of macroeconomic research at Dutch bank ING, there can be no “automatic reaction” to such a catastrophe.

In a scenario outlined by Brzeski, the United States could avoid a technical default for a few weeks by continuing to pay bondholders at the expense of other budget items, such as spending on social security and health benefits. That would be what Moody’s Analytics calls a “breach” of the debt ceiling. A default is not as serious as a default, which would only occur if the Treasury failed to make a payment on the debt on time.

In that case, markets would remain choppy, but “the mother of all crises” would not be unleashed, Brzeski said.

However, a default on a Treasury would trigger “immediate panic in the markets,” said Obstfeld of the Peterson Institute.

Moody’s Analytics economists believe that even in the event of a default lasting no more than a week, US gross domestic product (GDP) would decline by 0.7 percentage points and $1.5 million would be lost. of jobs. In a article published this month, assign a 10% probability to a default, adding that it will most likely be short-lived.

If the political stalemate drags on into the summer, with Treasury prioritizing debt payments over other bills, “the blow to the economy [estadounidense] would be cataclysmic,” they wrote. GDP would fall 4.6%, costing 7.8 million jobs. Stock prices would plummet, wiping out $10 trillion of household wealth, and the costs of loans would skyrocket.

A deep recession in the United States, triggered by a prolonged US default or default, would also sink the world economy.

In either scenario, if interest rates on US Treasury bonds, which are used to price countless financial products and transactions around the world, were to skyrocket, borrowing costs would skyrocket everywhere. The financial panic would cause the freezing of the credit markets and the collapse of the stock markets.

Investors, who traditionally buy Treasuries in times of crisis, could ditch them and turn to cash. The last time that happened, when the coronavirus pandemic was unfolding in March 2020, the Federal Reserve had to take extraordinary measures to avoid a full-blown liquidity crisis.

He slashed interest rates, launched a massive purchase of billions of dollars worth of bonds, offered huge cash injections to lenders, and opened lines of credit to foreign central banks to keep money flowing. dollars through the global financial system.

But the same measures may fall short if the solvency of the US government is in question.

“It’s not clear in a Treasury default crisis whether the Fed could do enough even with the kinds of efforts it deployed 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.”

Neel Kashkari, president of the Federal Reserve Bank of Minneapolis, is even more pessimistic. The Fed does not have “the ability to protect the US economy against the downside of a default,” he told News’s Poppy Harlow this week. “A default would send a message to investors around the world of an erosion of confidence in the United States,” she added.

The special power of the dollar

Even if confidence in the United States evaporates, the damage to the dollar could be limited. In 2011, the currency strengthened when the S&P downgrade led investors to take refuge in safe haven assets such as the dollar.

The pre-eminent role of currency in the global economy leaves investors with few alternatives in the event of a crisis, even when that crisis comes from the United States.

Between 1999 and 2019, the dollar represented 96% of commercial turnover in the Americas, 74% in the Asia-Pacific region, and 79% in the rest of the world. according to the Fed.

The greenback accounted for 60% of the world’s disclosed foreign exchange reserves in 2021, the bulk of which is held in the form of US Treasury bonds. The dollar is also the dominant currency in international banking.

“The argument in favor [del dólar] is that there really is nowhere else to go… It’s not clear exactly where people are running,” said Randy Kroszner, a former Fed governor and now professor of economics at the University of Chicago 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 government bond market of similar creditworthiness.

“There simply aren’t enough safe assets available for investors to get out of Treasuries,” says Josh Lipsky, director of the Atlantic Council’s Center for Geoeconomics.

But even if the dollar and Treasuries enjoy some protection by virtue of their preponderant role in international trade and finance, that does not mean that the consequences of a US default are not serious.

“The bottom line,” Lipsky said, “is that in a default, even if US Treasuries gain in the short term, the whole world — including the US — will still lose.”

— Robert North contributed to this reporting.