What would happen if the US defaults on its debt?

Once again, the usual political tug-of-war in the US Congress triggered by the cyclical need to raise the debt ceiling is accompanied by media hysteria about a possible default. But is there a real possibility that the country could default, and what would be the consequences for the global economy?

 

Unlike other countries, where government spending is capped, in the United States, Congress sets a ceiling on the amount of federal debt – currently set at $31.381 trillion – that the government can acquire to finance its spending and obligations. The debt ceiling does not limit the government’s ability to incur spending but rather restricts the issuance of Treasury bonds, i.e. new debt that it uses to meet its financial obligations. The theory is that by limiting the amount of debt that can be accumulated, spending will be restricted.

The debt ceiling was first established in 1917 to finance the United States’ entry into the First World War. Since then, it has been raised 102 times by the legislature. This limit has become especially relevant recently because of the country’s chronically high budget deficit. Policies focused on military spending and social programmes, lower tax revenues due to tax cuts, and the impact of the pandemic are some of the factors that have contributed to the public deficit.

In practice, however, limiting the debt ceiling has proved wholly insufficient in controlling the debt. The government continues to spend money at a deficit and the debt continues to grow, and worse, it is used as an excuse to fuel political blackmail between the two dominant parties, who often jeopardise the economic health of the country for their own self-interests. As European Central Bank president Christine Lagarde recently declared, “I understand politics, but there comes a time when the higher interests of the nation have to prevail”.

The importance of the debt ceiling was highlighted in 2011 when Congress came close to failing to raise the limit, which would have led to a US government default. Former President Barack Obama was forced to cut spending on social programmes to reach a political deal to raise the debt ceiling and avoid default. A political tug-of-war that led to the only credit rating downgrade in the country’s history.

 

Implementation of extraordinary measures

On 19 January, President Joe Biden’s administration reached the debt ceiling of $31.381 trillion, so the country cannot issue any more bonds to finance itself. This means that if an agreement is not reached with the opposition this summer, the country will enter technical bankruptcy. Although the first meeting to advance negotiations between House Speaker Kevin McCarthy and the speaker took place on 1 February, the White House and Republican leaders in Washington are far from reaching a deal to avert disaster.

The Treasury Department can use a range of accounting manoeuvres to pay the government’s bills, but these extraordinary measures are temporary and can only prevent a default until 5 June. Once these measures and the available cash are exhausted, the repercussions could be devastating for the country’s economy.

In this context, Treasury Secretary Janet Yellen announced to members of Congress that she planned to redeem existing investments and suspend new investments from the Civil Service Retirement and Disability Fund and the Postal Fund. As well as suspending reinvestment in government securities bonds from the federal workers’ retirement and savings plan. 

Consequences of a default

Despite the low probability of a default – approximately 2%, according to modelling by research provider MSCI shared exclusively with CNN – if no agreement is finally reached, the country would be left without sufficient liquidity to meet all its payments. Firstly, it would enter into what is known as a technical default, which is a prolonged period of default on some or all of the country’s financial liabilities. This would double the unemployment rate and possibly trigger an economic recession, increasing inflationary pressure. In addition, the US credit rating would be downgraded, just as in 2011.

Even more serious would be a real default, in which the government would run out of money to pay its obligations, causing an economic catastrophe. The consequences are virtually unpredictable, as there is no contemporary precedent, but some economists predict that unemployment would soar to over 12% and the economy would shrink by more than 10%, triggering a deep recession that would trigger inflation.

In addition, Social Security payments and federal pensions could cease, accompanied by massive lay-offs of public administration employees, affecting the security forces, the transport department and the airport administration, which would stop their activity unless the government implemented emergency measures.

Given the globalisation of the monetary system and the fact that about 75% of US government debt is held by domestic and foreign investors – including governments of other countries that account for about a third of this public debt – such a default would likely cause not only the American but the world economy to plummet.

On the other hand, many countries with economic ties to the United States depend on the stability of the US economy and, in return, on the dollar. A suspension of payments would raise borrowing costs for the US government and businesses, but also for other countries, slowing down investment, neutering global economic growth and pushing up the price of gold as a safe-haven asset in the face of collapsing economies. Moreover, this crisis would further accelerate a decoupling from the established, US-dominated monetary system, by the large emerging economies that have been working for years to lay the groundwork of a multipolar world with an alternative monetary system.

 

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  1. Mercè ComasMercè Comas says:
    Mercè

    Interessant veure com estiren la corda els dos partits d’una de les grans potències mundials. Ens tindran entretinguts com a l’any 2011.
    Aniria bé també saber com ho fan les altres.

    • Jordi CollJordi Coll says:
      Jordi

      Cert, però hi han tantes corrupteles en el món polític…, que fa fàstic. Moltes gràcies pel teu comentari, Mercè!!!

      10 months ago
  2. Joan Santacruz CarlúsJoan Santacruz Carlús says:
    • Jordi CollJordi Coll says:
      Jordi

      Gràcies a tu, Joan, per ser-hi i per seguir-nos!!!

      10 months ago

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