WASHINGTON – If the debt crisis rocking Washington eventually sends America into recession, the U.S. economy will collapse on itself.
The consequences of a first-time federal debt default will reverberate quickly around the world.
Chinese factories selling electronics to the US may run out of orders.
Swiss investors holding US Treasuries could suffer losses. Sri Lankan companies cannot use dollars as a substitute for their suspect currency.
“No corner of the world economy can escape” if the U.S. government defaults and the crisis is not resolved soon, said Mark Jandy, chief economist at Moody’s Analytics.
Jandy and two Moody’s colleagues concluded that even a more than one-week breach of the debt ceiling would weaken the U.S. economy so rapidly that it would eliminate 1.5 million jobs.
If the government default lasts long enough, until the summer, the consequences will be dire, Jandy and his colleagues found in their study: US economic growth, the unemployment rate, will rise from 3.4% to 8% now. A stock market crash could wipe out $10 trillion in household wealth.
Of course, it may not come.
Negotiations
The White House and House Republicans, seeking a breakthrough, ended a round of debt ceiling negotiations on Sunday and plan to resume talks on Monday.
Republicans have threatened to let the government default on its debt by refusing to raise the legal limit on borrowing unless President Joe Biden and Democrats agree to sharp spending cuts and other concessions.
The worrying fact is that most financial activity depends on the belief that the United States will always pay its financial obligations.
Its credit, long seen as an ultra-safe asset, is the bedrock of global trade, built on decades of trust in America.
A default could disrupt the $24 trillion market for Treasury debt, freeze financial markets and trigger an international crisis.
“A debt default would be a catastrophic event, with unpredictable but dramatic effects on US and global financial markets,” said Ishwar Prasad, a professor of trade policy at Cornell University and a senior fellow at the Brookings Institution.
The threat comes as the global economy faces a host of threats, from rising inflation and interest rates to the continued fallout from Russia’s invasion of Ukraine and the tightening grip of authoritarian regimes. Above all, many countries are skeptical of America’s excessive role in global finance.
In the past, U.S. political leaders have typically stepped back from the brink and managed to raise the debt ceiling before it was too late. Congress has raised, revised or extended the borrowing limit 78 times since 1960, most recently in 2021.
However, the problem only got worse. The debt has grown after years of increased spending and sharp tax cuts, while partisan divisions in Congress have widened. Treasury Secretary Janet Yellen has warned that the government could default as early as June 1 if lawmakers do not raise or suspend the ceiling.
“If (Treasuries’) credibility suffers for any reason, it will send shock waves through the system … and have major consequences for global growth,” said Maurice Obstfeld, a senior fellow at the Peterson Institute for International Economics and former chief economist of the International Monetary Fund.
Treasuries are widely used as collateral for loans, against bank losses, as a haven in times of great uncertainty, and as a place for central banks to park foreign exchange reserves.
US Government Debts
Given their perceived safety, US government debt (Treasuries, bonds and notes) has a risk weight of zero under international banking regulations. Foreign governments and private investors hold nearly $7.6 trillion in debt, about 31% of Treasuries in financial markets.
Because the dominance of the dollar made it the de facto global currency after World War II, it was relatively easy for the United States to borrow and finance the pile of public debt.
But the high demand for dollars makes them more valuable than other currencies, and that imposes costs: A strong dollar makes U.S. goods more expensive relative to foreign competitors, putting U.S. exporters at an uncompetitive disadvantage. This is one of the reasons the US has run a trade deficit every year since 1975.
US Dollars
Of all foreign exchange reserves held by the world’s central banks, US dollars account for 58%. Number 2 Euro: 20%. China’s yuan is worth less than 3%, according to the IMF.
Federal Reserve researchers calculated that from 1999 to 2019, 96% of trade in the United States was invoiced in US dollars. Asia accounted for 74% of the trade. Elsewhere outside Europe where the euro dominates, dollars account for 79% of trade.
The U.S. currency is so reliable that merchants in some unstable economies demand payment in dollars rather than their home country’s currency. Consider Sri Lanka, plagued by inflation and a skyrocketing local currency.
Earlier this year, distributors refused to deliver 1,000 containers of urgently needed food unless paid in dollars.
As importers could not come up with dollars to pay suppliers, exports piled up at Colombo ports.
“Without (dollars), we cannot do any transaction,” said Nihal Senaviratne, spokesman for the Essential Food Importers and Traders Association. “When we import, we have to use hard currency, mainly US dollars.”
Similarly, many shops and restaurants in Lebanon must pay in dollars as inflation rises and the currency depreciates.
When Ecuador changed its currency
In 2000, Ecuador responded to an economic crisis by replacing its own currency, the sucure, with the dollar, a process known as “dollarization,” and it remained strong.
Even with the crisis in the US, the dollar remains a safe haven for investors.
In late 2008, the collapse of the US housing market brought down hundreds of banks and financial institutions, including the once-mighty Lehman Brothers: the dollar soared.
“Even though we were the problem, we, the United States, still had a flight to quality,” said Clay Lowry, who oversees research at the Institute of International Finance, a banking trade group. “The dollar is king.”
Will the dollar rise again?
If the U.S. breaches the debt ceiling without resolving the dispute and the Treasury defaults, “the dollar will rise again because of uncertainty and fear,” Zandy says. Global investors don’t know where to turn when a crisis hits, and that’s America.
But the Treasury market will probably stall. Instead, investors can move money into U.S. money market funds or bonds of top U.S. companies. Ultimately, Jandy says, growing doubts will devalue the dollar and keep it low.
On the debt ceiling crisis, Lowry, who was undersecretary of the Treasury during the 2008 crisis, envisions the U.S. continuing to pay bondholders interest. It will try to pay its other obligations to contractors and pensioners, for example, in the order in which those bills are due and when money is available.
For example, for invoices due on June 3, the government may pay on June 5. There will be some relief on June 15. Government revenue will come from the estimated tax payments of many taxpayers in the second quarter.
Lowery said unpaid workers, “anyone living on veterans’ benefits or Social Security,” are likely to sue the government. And even if the Treasury continues to pay interest to bondholders, rating agencies will downgrade U.S. debt.
The dollar, while still dominant globally, 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 resent how fluctuations in the value of the dollar can affect their own currencies and economies.
A rising dollar can trigger crises abroad by attracting investment from other countries and increasing the cost of repaying dollar-denominated loans. America’s willingness to use the dollar’s influence to impose financial sanctions against rivals and adversaries is viewed with concern by some other countries.
However, no clear alternatives have yet emerged. The euro lags the dollar significantly. Even more
