The global economy has been hit by two massive shocks in three years and a third in the form of the US debt crisis may be imminent. After the coronavirus pandemic, and the first great war in Europe since 1945, that of Ukraine, the specter of the inability of the American government to pay its bills now haunts the financial markets.
And it may not happen after all, as there were signs on Friday (05/26) that negotiations in Washington to increase the amount the government can borrow were gaining momentum. But if so, it could make the 2008 global financial crisis look like a walk in the park.
The consequences of bankruptcy would be “a million” times worse, said Danny Blanchflower, professor of economics at Dartmouth University and former rate regulator at the Bank of England. “What if the world’s largest financial monolith can’t pay its bills? The consequences are terrifying“.
Confidence that the US government will pay its creditors on time strengthens the smooth functioning of the global financial system. This makes the dollar the world’s reserve currency and US Treasury securities the foundation of bond markets around the world, CNN reports.
“If the credibility of the Treasury’s payment commitment is called into question, it could wreak havoc on a number of global marketssaid Maurice Obstfeld, senior fellow at the Peterson Institute for International Economics, a think tank in Washington.
During the 2011 standoff over raising the US debt ceiling, the S&P 500 Index of major US stocks fell more than 15%. The index continued to fall even after a deal was struckwhich happened just hours before the government ran out of funds.
Stock markets have largely avoided a potential default so far, even as the so-called X date of June 1 approaches. That’s when the government, unable to borrow more, could run out of money, according to Treasury Secretary Janet Yellen, who still believes a deal will be struck in time.
“One of my concerns is that even in the face of a deal – when it happens – there could be significant disruption in financial markets“, he said on Wednesday.
Fitch has already put America’s AAA credit rating, its highest rating, on close watch for possible downgrade due to political events.
The move brought back memories of 2011, when S&P downgraded the United States from “AAA” to “AA+.” S&P has yet to restore that perfect credit rating more than a decade later.
Any downgrade, no matter how small, affects the price of billions of dollars of US public debt and drives up future borrowing costs. Short-term Treasury yields have already risen and US mortgage rates have soared amid uncertainty.
Worse and worse
There is no historical precedent for a US bankruptcywhich makes it impossible to predict its evolution and difficult for institutions to prepare.
This was highlighted in a comment this week by the head of one of the world’s biggest lenders. World Bank President David Malpass told CNN that the institution does not have a “special war room” to manage the threat. “I don’t expect a defect“, he added.
Such a “war room” exists at JPMorgan Chase. CEO Jamie Dimon told Bloomberg earlier this month that the bank held weekly meetings to prepare for a potential US default and that until May 21, it should meet every day.
For Carsten Brzeski, head of macroeconomic research at the Dutch bank ING, there can be no “automatic reaction” to this disaster.
In a scenario described by Brzeski, the United States could avoid a technical default for a few weeks by continuing to pay bondholders at the expense of other budget items, such as Social Security and health care spending. This would be where Moody’s Analytics calls it “exceeding” the debt ceiling. A default is not as serious as a default, which would only occur if the Treasury failed to repay the debt on time.
Markets would still be shaken in such a scenario, but it wouldn’t trigger “the mother of all crises,” Brzeski said. However, if a Treasury bond defaults, it would trigger an ‘immediate market panic’noted Obstfeld of the Peterson Institute.
Moody’s Analytics economists estimate that even in the event of a breach lasting no more than a week, US GDP would fall by 0.7 percentage points and 1.5 million jobs would be lost. Writing in a study this month, they put a 10% chance of a breach, adding that it was very likely to be brief.
If the political stalemate continues this summer, with the Treasury prioritizing debt repayments over other bills, “the blow to the economy [των ΗΠΑ] it would be stormy“, they wrote. GDP will fall by 4.6%, costing 7.8 million jobs. Stock prices would collapse, wipe out $10 trillion in household wealth and borrowing costs would rise. sharply.
A deep US recession, caused by a prolonged US breach or default, would also sink the global economy.
In each of these scenarios, if interest rates were to rise on US Treasuries – which are used to fix the price of countless financial products and transactions around the world – then borrowing costs would skyrocket everywhere. Financial panic would cause credit markets to freeze and stock markets to crash.
Investors, who traditionally buy bonds in times of crisis, could abandon them and turn to cash. The last time this happened, when the coronavirus pandemic unfolded in March 2020, the Federal Reserve had to take emergency action to avoid a full-scale liquidity crisis.
He slashed interest rates, embarked on a multi-billion dollar bond-buying spree, offered massive cash injections to lenders and opened lines of credit to foreign central banks to maintain the flow of dollars in the global financial system.
However, the same measures may fail if the solvency of the US government is challenged.
“It’s unclear in a Treasury default crisis whether the Fed could do enough, even as it did in March 2020said Obstfeld. “It would take a much greater effort to stabilize the market, and that effort may well be partially successful…or not very successful at all.“.
Neel Kashkari, president of the Federal Reserve Bank of Minneapolis, is even more pessimistic. The Fed”it does not have the capacity to protect the US economy from the decline of a defaulthe told CNN this week. “A default would send a signal to investors around the world about eroding trust in America“, he added.
The special power of the dollar
Even if confidence in the United States goes up in smoke, dollar damage could be limited. In 2011, the currency rallied as the shock of the S&P downgrade prompted investors to rush into safe-haven assets such as the US dollar.
The prominent role of money in the global economy leaves few alternatives for investors in times of crisis, even when that crisis comes from the United States.
Between 1999 and 2019, the dollar accounted for 96% of trade tariffs in the Americas, 74% in the Asia-Pacific region and 79% in the rest of the world, according to the Fed.
Dollars accounted for 60% of reported global foreign exchange reserves in 2021, most of which are held in the form of US Treasury bonds. The dollar is also the dominant currency in international banking.
“The argument for this [του δολαρίου] it’s that there’s really nowhere to go… We don’t know exactly where people will turnsaid Randy Kroszner, former Fed governor and now professor of economics at the University of Chicago Booth School of Business.
Ultimately, the same argument could help prop up the $24 trillion market for US Treasuries, which is an order of magnitude larger than any similarly creditworthy government bond market.
“There simply aren’t enough safe assets available for investors to get out of bondssaid Josh Lipsky, senior director of the Atlantic Council’s Center for Geoeconomics.
But even if the dollar and bonds enjoy some protection because of their important role in international trade and finance, this does not mean that the consequences of a US default would not be serious.
“The conclusion“, said Lipsky, “is that in the event of a default, even if the US Treasury gains in the short term, everyone – including the US – will still lose“.
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