Debt Ceiling Blues, Part 79. What Happens if the US Defaults?

US Debt Ceiling, US Dollar, US Default, US Treasury, Janet Yellen – Talking Points:

• The US Government has reached its borrowing limit
• There should be a deal to raise it
• But such a thing still looks elusive in a riven Congress

There’s a particular long-running piece of political theater with which the United States rather ghoulishly entertains itself and, increasingly, the wider world. A farce in seventy-eight acts (so far), since 1960. It’s called “Raising the Federal Debt Ceiling”.

Technically there is a limit on how much money the US government is allowed to borrow. This idea was baked only vaguely (if at all) into the Constitution but, as time went on, it became codified in various public debt acts and their numerous amendments. Of course, while there is a borrowing limit, Congress has always in the past simply raised it, often just in time, before the government runs out of money without the legal means to borrow any more.

Even the most partisan political show-ponies realize that debt default, the alternative to ceiling-raising, would swiftly turn farce into tragedy.

You may have spotted by now that the ceiling is in effect an executive fiction, one that the world is by and large happy to believe in.

For the US Dollar has long been the world’s reserve currency and by far the most-used unit in international commerce. It overcame all rivals to reach that dizzy height, displacing Sterling at the top of global trade back in the 1930s. It has since seen off all possible comers since, from the one-time contender Japanese Yen to bold upstarts like the Euro and Chinese Yuan. All sorts of global markets, contracts and derivative products are benchmarked against the Dollar, usually far more than all other comparable products put together.

The Dollar Has No Plausible Rival

There’s simply nothing that can match the depth and liquidity of US markets, to the point where it’s quite legitimate to talk about a “Dollarized” world financial system. The deepest pools of capital for everything from stocks and bonds to oil and gold are all in the Dollar.

US debt is also supposed to be the world’s pre-eminent ‘risk free’ investment. Why so? Well, because the United States federal government never defaults on its debt.

So, make no mistake, on some level, the US debt ceiling affects us all.

And now the seventy-ninth act is upon us. For the US hit its debt ceiling this week. The thing currently stands at $31.4 trillion dollars and that’s where we are. So, the federal government now finds itself legally unable to borrow more money until Congress decides to suspend or raise the ceiling.

And what has happened seventy-eight times before (three of them in the last six months) is that the ceiling has simply been raised. But now Republicans control the House of Representatives and they want spending cuts which the Democrats in the Senate and, of course, the White House, say they won’t permit.

This gridlock has raised serious concerns that this time farce could morph into tragedy, potentially leading to the first intentional debt default in the history of the Republic.

Sadly, there’s still room for political brinkmanship because the US Treasury can manage the situation at least temporarily. In the past this has included steps like suspending investments it’s meant to make into retirement and health benefits for federal employees, only to top them up once the ceiling has been raised. Treasury Secretary Janet Yellen has announced a package of such measures. She thinks that could keep the government above water until around June.

Now, despite the current impasse, it’s overwhelmingly likely on all past evidence that the two main parties will eventually come together and raise the ceiling.

Data Source: Bank of International Settlements

So, What Happens If Congress Can’t Agree?

But what if they don’t? What would happen if the unthinkable occurs and the US does in fact default on its debts?

The practical, domestic consequences would be bad enough, with federal salaries unpaid, along with military ones, medical care payments and a host of other outlays usually deemed essential, not least those interest repayments on the national debt.

The United States credit rating would be downgraded, with the government obliged to pay higher interest rates to get its bonds sold. Of course, Washington would remain “investment grade” but the global bond market would have seen its anchor slip for the first time. And that would be a hugely uncomfortable experience.

But the horrors of debt default would soon break free of their homeland and ripple out into the wider world. Other reserve currencies such as the Euro and Yen would see a huge influx of funds at the expense of a tanking Dollar. And don’t forget, many currencies operate within a “Dollar peg” system which explicitly links them to the US currency. They would all experience significant dislocation should the US default.

US import prices would likely also rise extremely sharply, reigniting inflation just when it looked to be cooling down.

The timing would be appalling too. Clearly there’d never be a good time for Washington to fail in its obligations. But a world only just recovering from Covid and still chafing under the burdens of inflation and Russia’s invasion of Ukraine really wouldn’t need another huge problem. A US debt default would probably nail on a deep global recession.

Even so, it’s important not to get too dramatic. A debt default arising from political gridlock would be nasty, but that very fact would probably see the impasse broken. Eventually that ceiling would be raised again, and the federal debt train would trundle on. Dollar appetite took years to build. It’s not going to vanish overnight.

But default is a financial nuclear option that would leave the Greenback forever diminished. Some will feel that even a humbled USD has no plausible rival, and they’d have a point.

But in the end, it’s extremely doubtful that Congress will consider a real world test of that point.

Isn’t it?

— by David Cottle for DailyFX