After the recent meeting between US President Joe Biden and congressional leaders, no breakthrough was made on the issue of raising the US government’s debt ceiling. As a result, concerns are growing over the potential “catastrophic” impact on both the US and global economies if the US defaults on its obligations.
Failure to raise the debt ceiling could lead to the US government being unable to pay its bills from as early as June 1, which could result in a recession in the US and severe consequences for the global economy. US officials and analysts have warned that while US officials often reach a deal at the last minute, brinksmanship over the issue could still create instability in global financial markets.
The budding fallout
The on-going debate over raising the US government’s debt ceiling has sparked concerns among economists, including Roger Ferguson of the Council on Foreign Relations, that the US may default on its debts. This scenario, if it were to happen, could lead to chaos for the US and global economies, according to experts. Even if the debt ceiling is not breached, hitting it would seriously hamper the government’s ability to fund its operations, such as providing for national defense and entitlements like Social Security and Medicare.
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The potential repercussions of hitting the ceiling include a downgrade by credit rating agencies, higher borrowing costs for businesses and homeowners, a drop in consumer confidence, and a possible recession. According to Goldman Sachs economists, breaching the debt ceiling would immediately halt about one-tenth of US economic activity. In case of default, the consequences could be much worse, including the loss of three million jobs, a $130,000 increase in the cost of an average thirty-year mortgage, and a national debt increase of $850 billion.
Higher interest rates could also divert future taxpayer money away from critical federal investments in infrastructure, education, and healthcare. Treasury Secretary and former Federal Reserve Chair Janet Yellen has warned Congress that failing to meet the government’s obligations would cause irreparable harm to the US economy, the livelihoods of Americans, and global financial stability.
The potential domino effects
According to experts, a U.S. default could have catastrophic consequences for the global financial markets. The U.S. dollar has been the world’s reserve currency, largely due to the creditworthiness of U.S. treasury securities. Any damage to confidence in the U.S. economy, whether from a default or uncertainty around it, could result in investors selling U.S. treasury bonds and thus weakening the dollar. As over half of the world’s foreign currency reserves are held in U.S. dollars, a sudden decrease in the currency’s value could have far-reaching consequences for the market for treasuries, causing the value of these reserves to plummet.
With many heavily indebted low-income countries already struggling to make interest payments on their sovereign debts, a weaker dollar could increase the relative cost of debts denominated in other currencies, potentially tipping some emerging economies into debt crises.
Although a weaker dollar could make U.S. exports more competitive by effectively making them cheaper, U.S. firms could face higher borrowing costs from rising interest rates. The dollar’s instability could also benefit China, which has long sought to promote the use of its renminbi as a global reserve currency. However, the currency accounts for less than 3 percent of the world’s allocated foreign reserves.
Options for the Government
According to experts, failure to raise the debt ceiling by Congress could lead to a U.S. default, which would have severe consequences for the U.S. and global economies. It could damage the creditworthiness of U.S. treasury securities, which have long supported the demand for U.S. dollars and its status as the world’s reserve currency. This could lead to a decrease in the value of the U.S. dollar and prompt investors to sell U.S. treasury bonds. More than 50% of the foreign currency reserves held globally are denominated in U.S. dollars. Therefore, a sudden decline in the value of the dollar could have a ripple effect on the treasury market, as the value of these reserves decreases.
The Treasury can delay default by employing “extraordinary measures,” such as suspending payments to some government employee savings programs and delaying auctions of securities. While the Treasury has used these measures when negotiations have previously stalled, a long impasse over the debt ceiling can shake investor confidence and prompt a credit rating downgrade, increased borrowing costs, and a drop in consumer confidence that could shock the U.S. financial market and tip the economy into recession.
The failure to raise the debt limit despite such emergency measures could lead to federal spending cuts or significant tax increases. However, these processes are viewed as time-consuming, and experts have warned that political brinksmanship that engenders even the prospect of default could be disruptive to financial markets and American businesses and families. Treasury Secretary Yellen has warned that extraordinary measures could be exhausted by June 1, 2023, if the debt limit is not raised.
Probable impacts on dollar dominance and geopolitics
The potential consequences of the U.S. defaulting on its debt are significant, particularly in terms of the global economy and the role of the U.S. dollar as the world’s primary unit of account. Over half of world trade is currently conducted in U.S. dollars, giving the U.S. government and American companies a significant advantage in international trade and finance. Other countries must either export more than they import or borrow more dollars or euros to pay their foreign debt, whereas the U.S. is free from these constraints and can run up large trade deficits without facing the same consequences.
The dominance of the U.S. dollar also means that American companies are not as subject to exchange rate risk as their foreign competitors, as they can buy and sell in their own currency. This gives them a significant competitive advantage in international trade. If the U.S. were to default on its debt, the dollar would likely lose its position as the international unit of account, forcing the government and companies to pay their international bills in another currency.
Furthermore, the dollar’s dominance gives the U.S. significant political power, as trade must go through an American bank at some point. This has allowed the U.S. to impose economic sanctions on countries such as Iran and Russia, limiting their access to the dollar and causing significant economic pain. No other country could unilaterally impose this level of economic punishment on another country. Overall, defaulting on its debt could have far-reaching consequences for the U.S. economy and its position in the world.
