U.S. lawmakers have less than three weeks to avoid a default on the country’s sovereign debt by increasing the limit on the amount of money the Treasury Department can borrow. Failure to do so would cause the United States to deliberately default on its debts for the first time in history.
By now, the extent of the damage economists predict the U.S. economy would suffer in the event of a default sparked by a bitter conflict between Congressional Democrats and Republicans has been widely reported.
A Moody’s Analytics estimate earlier this month predicted that in a protracted default scenario, the United States would enter a recession, with gross domestic product falling nearly 4%. Some six million jobs would be lost, pushing the unemployment rate to 9%. The resulting stock market liquidation would wipe out $ 15 trillion in household wealth. In the short term, interest rates would skyrocket, and in the long term, they would never fall to their pre-default low.
But the damage caused by a US default would not be limited to the United States itself. Securities issued by the United States have been so reliable for so long that they are considered essentially risk-free in the financial markets and are used to back up a large number of financial contracts around the world.
âThe US Treasury market is the world’s flagship asset,â said Jacob Kirkegaard, senior researcher at the Peterson Institute for International Economics. “If it turns out that this asset is not really risk free, but that it may in fact default, it would detonate a bomb in the middle of the global financial system. And it would be extremely messy.”
In the event of default, it is generally assumed that there would be a large sale of Treasury securities, called Treasuries. This would happen for multiple reasons – from individual investors afraid of default, to companies that had loans secured with treasury bills being forced to replace them with something the lender considers more secure.
The massive sale would make it more expensive to borrow from the United States in the future, pushing up interest rates in the United States and lowering the value of the dollar against other world currencies.
Here are five ways in which these effects would trickle down to the global economy.
Reduced world trade
If a default drove the United States into a recession, American consumers and businesses would reduce the amount of goods and services they buy outside the country.
While this would affect virtually all countries to some extent, emerging countries that depend on exports to the United States for a large portion of their income would be particularly affected.
The expected devaluation of the dollar would have a similar impact – making it more expensive for US companies to purchase supplies abroad, resulting in an even greater reduction in trade.
Dollarized economies would suffer
The US dollar is a common currency in much of the world. Some countries have adopted it as the official currency, while in others it coexists with a local currency which is often âpeggedâ to the dollar to keep its value stable.
In the event that a default lowers the value of the dollar, countries with heavily dollarized economies would see the purchasing power of the existing currency stock decrease.
âEmerging markets would suffer greatly because they would not have a very credible national currency,â Kirkegaard said.
Affected commercial contracts
Around the world, many cross-border transactions require settlement in US dollars. In ordinary times, this is seen as a convenient way to ensure that sudden fluctuations in the value of a local currency do not significantly disadvantage a party in a transaction that needs to be settled in the future.
A sudden and sharp drop in the value of the dollar would mean that individuals and businesses anticipating payment for existing contracts in dollars would effectively receive less than they expected for their goods and services.
More sophisticated commercial contracts may contain anti-default clauses that require the renegotiation of agreements in the event of a default that lowers the value of a reserve currency. While this would keep both parties in an entire contract, it would complicate and likely slow down many transactions.
Capital flees the United States
One of the economic advantages that the United States has long enjoyed is that it attracts global capital. When the global economy is strong, investors looking for growth pay American companies money. When times are tough, investors seek refuge in US Treasuries. Either way, global markets are directing capital to the United States
But when interest rates rise for the wrong reason – because investors don’t trust the US government to pay its debts – that system is broken.
The result is that, to some extent, investors seeking shelter would be more cautious about assuming that Treasury securities are the investment of choice for protecting the value of their assets. The logical step would be for them to start directing at least part of their investments to securities issued by other governments and denominated in different currencies.
New reserve currency
A side effect of these new capital flows could be a challenge for the dollar as a global âreserve currencyâ.
A reserve currency is money held by a country’s central bank and major financial institutions in order to facilitate global trade by domestic companies, meet international debt obligations, and influence exchange rates. national currency, among other reasons.
The stability of the dollar has made it the dominant global reserve currency since the end of World War II. This has generated a constant global demand for dollars, allowing the U.S. government to borrow at lower interest rates than other major nations.
Global competitors of the United States, including China and Russia – but even allies, like the European Union – have suggested for years that it would be better if the dollar’s dominance was not as complete as it is. ‘is.
There has been little movement to reverse the dollar in recent decades, but a shock like a default on US debts could persuade some countries to hedge their bets by taking other currencies, like the euro or the renminbi, in addition to their reserves.
“If you are China or, for that matter, the euro zone, you wanted to replace or supplant the dominant role of the dollar in the world economy by the renminbi or the euro,” Kirkegaard said. “You couldn’t ask for better.”