How the rest of the world’s economy would be affected if the U.S. defaults on its debts

If the debt crisis plaguing Washington eventually sends the United States tumbling into recession, its economy will hardly sink.

The repercussions of the first default on the federal debt will quickly reverberate around the world.

“No corner of the global economy will be saved” if the US government fails and the crisis is not resolved quickly, said Mark Zandi, chief economist at Moody’s Analytics.

Zandi and two colleagues at Moody’s have concluded that even if the debt limit is violated in no more than a week, the US economy will collapse so much, so quickly, that it will eliminate 1.5 million jobs.

And if the government standards will last longer – until the summer – the consequences will be more dire, Zandi and his colleagues found in the analysis: US economic growth will sink, 7.8 million American jobs will be lost, debt levels will jump. , the US unemployment rate will soar from the current 3.4 percent to eight percent and the stock market plunge will wipe out $10 trillion US in household wealth.

Of course, it may not come.

The White House and House Republicans, seeking a breakthrough, continue to negotiate the debt limit. US President Joe Biden met with House Speaker Kevin McCarthy Monday, with both describing the conversation as “productive.”

Still, Republicans have threatened to keep the government from paying off the debt by refusing to raise statutory limits on what it can borrow unless Biden and Democrats accept spending cuts and other concessions.

Potentially ‘cataclysmic’

Much financial activity around the world depends on the belief that the US will pay its financial obligations. Its debt, long considered the safest asset, is the foundation of global trade, built on decades of trust in the United States. A default could destroy the US$24 trillion market for Treasury debt, freeze financial markets and trigger an international crisis.

“A debt default would be a cataclysmic event, with unpredictable but possibly dramatic fallout in the US and global financial markets,” said Eswar Prasad, professor of trade policy at Cornell University and senior fellow at the Brookings Institution.

The threat comes as the world economy grapples with a range of threats – from rising inflation and interest rates to the fallout from Russia’s invasion of Ukraine to tightening authoritarian regimes.

In addition, many countries distrust America’s large role in global finance.

In the past, American political leaders were generally able to avoid the brink and raise the debt limit before it was too late.

Congress has raised, modified or increased the debt ceiling 78 times since 1960, most recently in 2021.

So what’s different this time?

The problem has gotten worse. Partisan divisions in Congress have widened as the debt mounts after years of spending and deep tax cuts. US Treasury Secretary Janet Yellen has warned that the government could fail on June 1 if lawmakers do not raise or delay the ceiling.

“If you can believe it [Treasurys] will be flawed for any reason, it will send shock waves through the system … and have huge 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.

Treasurys are used as collateral for loans, as a buffer against bank losses, as a refuge in times of uncertainty and as a place for central banks to store foreign exchange reserves.

Because of its perceived safety, US government debt – Treasury bills, bonds and notes – carries a zero risk weight under international bank regulations. Foreign governments and private investors owe almost $7.6 trillion – about 31 percent of Treasurys in financial markets.

Because the dominance of the US dollar has been the de facto global currency since World War II, it has been very easy for the United States to borrow and finance its ever-growing pile of government debt.

Expected for dollars

But the high demand for the US dollar also tends to make people more valuable than other currencies, and that imposes costs: A strong dollar makes American goods pricier relative to foreign competitors, leaving US exporters at a competitive disadvantage. This is one of the reasons why the United States has run a trade deficit every year since 1975.

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 at 20 percent. China’s yuan is less than three percent, according to the IMF.

Researchers at the Federal Reserve have calculated that from 1999 to 2019, 96 percent of trade in America has been invoiced in US dollars. So is 74 percent of trade in Asia. Elsewhere outside Europe, where the euro dominates, the dollar accounts for 79 percent of trade.

So trusted is America’s currency that merchants in some unstable economies demand payment in dollars, rather than their own country’s currency.

Consider Sri Lanka, which has been plagued by inflation and a devaluation of the local currency. Earlier this year, shippers refused to release 1,000 containers of desperately needed food unless paid in dollars. Shipments are piling up at the docks in Colombo because importers can’t get dollars to pay suppliers.

“Without [U.S. dollars]we cannot do any transactions,” said Nihal Seneviratne, spokesman for the Importers and Traders Association of Essential Foods. “When we import, we have to use hard currency – usually US dollars.”

In addition, many shops and restaurants in Lebanon, where inflation has raged and the currency has plunged, demand payment in dollars. In 2000, Ecuador responded to the economic crisis by replacing its own currency, the sucre, with the dollar – a process called “dollarization” – and it has stayed that way.

If the United States will breach the debt limit without resolving the dispute and the Treasury fails to pay, Zandi suggests that the dollar will rise, at least initially, “due to uncertainty and fear. Global investors will not know where to go, except where they go.” always leave when there is a crisis and go to the United States.”

But Financial markets are likely to be paralyzed. Investors may switch their money to US money market funds or top-rated US corporate bonds. Ultimately, Zandi said, the growing doubt will reduce the value of the dollar and keep it down.

Who will – and won’t – get paid

In the debt-ceiling crisis, Lowery, who was assistant secretary of the Treasury during the 2008 crisis, imagined that the United States would continue to pay interest to bondholders. And will try to pay other obligations – for contractors and retirees, for example – in the order that bills become due and money is available.

For a bill due on June 3rd, for example, the government may pay it on June 5th. A some relief will come around June 15. That is when the government revenue will pour in as many taxpayers make tax payments approximately for the second quarter.

The government will be sued by people who aren’t paid — “anyone living off veterans’ benefits or Social Security,” Lowery said. And rating agencies will downgrade the U.S. debt, even as the Treasury continues to pay interest to bondholders.

The debt ceiling drama is sure to raise questions about the financial strength of the United States and the dollar.

“The global economy is in a fragile place right now,” Obstfeld said. “So spending the crisis on the credibility of US obligations is irresponsible.”