A US default would reverberate around the world

LANDRESS (CNN) — The global economy has experienced two major shocks in three years. A third of that could come from the US debt crisis.

Following the Covid pandemic and the first major war in Europe since 1945, fears of the US government’s inability to pay its bills are now haunting financial markets.

For most, this is unthinkable, and perhaps the consequences are dire. It will never happen: There were signs Friday that negotiations in Washington to increase the amount the U.S. government can borrow are gaining momentum. But if that happens, the global financial crisis of 2008 may seem like nothing.

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

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

“If the credibility of the Treasury’s payments commitment is called into question, it could wreak havoc across global markets,” said Maurice Obstfeld, non-resident fellow at the Peterson Institute for International Economics, a Washington think tank.

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

Even as June 1, the so-called X-date, approaches, equity markets have so far dismissed a possible default. The government could run out of money if it can’t borrow more, according to Treasury Secretary Janet Yellen, who continues to hope a deal can be reached in time.

“One of the concerns that I have is that even when a deal does happen, when it does, there could be a significant crisis in the financial markets,” he said on Wednesday.

Fitch has already put the U.S.’s triple-A credit rating, its highest score, on a possible downgrade watch due to riskier 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 yet to re-establish a perfect credit rating.

Any reduction, no matter how small, would affect the cost of trillions of dollars of U.S. government debt and raise borrowing costs in the future. Short-term Treasury yields have already risen and U.S. mortgage rates have risen amid uncertainty.

From bad to worse

There is no historical precedent for a default in the U.S., making it impossible to predict how it will play out and making it difficult for companies to prepare.

This was revealed this week by a director of one of the world’s biggest lenders. World Bank President David Malpass told CNN’s Julia Satterley that the agency does not have a “special war room” to manage the threat. “I don’t expect a default,” he added.

That “war room” is 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 through May 21.

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

In a scenario Brzeski outlines, the U.S. 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. Moody’s Analytics calls it a “breach” of the debt ceiling. A default is not as serious as default, only if the Treasury fails to pay the debt on time.

In that case, markets will be active, but the “mother of all crises” will not be unleashed, Bresky said.

Still, a Treasury default would “trigger immediate panic in markets,” said the Peterson Institute’s Opstfeld.

Economists at Moody’s Analytics believe that even a miss of more than a week would cause US gross domestic product (GDP) to fall by 0.7 percent and $1.5 million in lost jobs. A Article Issued this month, assign a 10% probability of default, which is likely to be short-lived.

If the political deadlock drags on into the summer and the Treasury prioritizes debt payments over other bills, it could be “a blow to the economy.” [estadounidense] “Would be catastrophic,” they wrote. GDP would fall 4.6%, 7.8 million jobs would be lost. Stock prices would collapse, $10 trillion in household wealth would be wiped out, and debt costs would rise.

A deep recession in the U.S., triggered by a prolonged U.S. default or default, would sink the global economy as well.

If interest rates on U.S. Treasuries, which are used to price a myriad of financial products and transactions around the world, rise, borrowing costs will rise everywhere. Financial panics can cause credit markets to freeze and stock markets to crash.

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

He lowered interest rates, began massive purchases of billions of dollars worth of bonds, gave huge cash injections to creditors, and opened loans to foreign central banks and dollars through the World Financial System to keep money flowing.

But those same measures could fall short if the U.S. government’s solvency is in question.

“It is unclear in the Treasury default crisis whether the central bank will be able to do enough even with the efforts deployed in March 2020,” Obstfeld said. “It takes a huge effort to stabilize the market, and that effort may be only partially successful…or not very successful.”

Minneapolis Federal Reserve Bank President Neel Kashkari is even more pessimistic. “The Fed lacks the ability to protect the US economy from the downside of a default,” he told CNN’s Poppy Harlow this week. “A default would send a message to investors around the world of declining confidence in America,” he added.

The special power of the dollar

Even if US confidence evaporates, the damage to the dollar may be limited. In 2011, the currency strengthened when S&P downgrades led investors to seek refuge in safe-haven assets such as the dollar.

The currency’s central role in the global economy leaves investors with few alternatives in the event of a crisis, even if that crisis comes from the United States.

Between 1999 and 2019, the dollar represented 96% of business revenue in the United States, 74% in the Asia-Pacific region, and 79% in the rest of the world. According to the central bank.

Greenbacks account for 60% of the world’s disclosed foreign exchange reserves in 2021, most of which are in the form of US Treasury bonds. The dollar is also the dominant currency in international banking.

“Argument in Support [del dólar] Can’t really go anywhere else.

Ultimately, the same argument could help prop up the $24 trillion U.S. Treasury market, an order of magnitude larger than any government bond market of similar creditworthiness.

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

But even though the dollar and Treasuries enjoy some protection through their leading role in international trade and finance, that doesn’t mean the consequences of a US default aren’t serious.

“By default, even if U.S. Treasuries gain in the short term, the entire world — including the U.S. — still stands to lose,” Lipsky said.

— Robert North contributed to this report.