In the last three years, there have been two major shocks to the global economy. The global economy could be in for a third shock, namely a US debt crises.
The financial markets are now haunted by the threat of the American government not being able to pay its bills after the Covid pandemic and the first major European war since 1945.
It's impossible for most people, possibly because of the terrifying consequences. It may not happen - there were signs on Friday that the negotiations to increase the amount of money the US government is allowed to borrow in Washington were moving forward. If it happens, the 2008 global financial crises could seem like a stroll in the park.
Danny Blanchflower is an economist at Dartmouth University, and a former interest rate setter at the Bank of England. He said that a default's consequences would be "a million" times worse. What happens if the largest economic monolith of the world is unable to pay its bills, asks Danny Blanchflower. The consequences are horrifying.
The smooth operation of the global financial systems is based on the belief that America will pay its debts on time. The dollar becomes the world's currency reserve and US Treasury Securities are the foundation of global bond markets.
Maurice Obstfeld is a non-resident senior Fellow at the Peterson Institute for International Economics in Washington.
The S&P 500, a leading US stock index, plunged by more than 15% during the 2011 standoff regarding raising the US debt limit. Even after the deal was struck, just hours before government funds ran out, the index continued to fall.
The stock markets have largely ignored the possibility of a default, even though the so-called X date of June 1 is approaching. Treasury Secretary Janet Yellen believes that the government will run out of cash if it is unable to borrow any more.
She said that she was concerned about the possibility of financial market turmoil even before an agreement is reached.
Fitch has placed America's highest credit rating, the triple-A, under watch due to political brinkmanship.
This move brought back the memories of 2011 when S&P downgraded America from 'AAA to AA+'. S&P still hasn't restored that perfect credit rating a decade after it was first given.
Every downgrade, no matter how small, has an impact on the price of US government bonds worth trillions of dollars and increases future borrowing costs. The yields on short-dated Treasury Bills have already risen and US mortgage rates have increased amid the uncertainty.
The worst is yet to come
It is impossible to predict the outcome of a US default and for institutions to be prepared.
The head of one of world's largest lenders made a comment on this topic last week. David Malpass, World Bank President, told CNN's Julia Chatterley the institution did not have a'special war room' for managing the threat. He added, 'I do not expect a default'.
JPMorgan Chase has a similar 'warroom'. Jamie Dimon, the CEO of JPMorgan Chase, told Bloomberg in early May that he was planning to hold daily meetings by May 21, to prepare for an eventual US default.
Carsten Brzeski is the global head of macroeconomics research at Dutch bank ING. He believes that there cannot be an 'automatic response' to this catastrophe.
Brzeski outlines a scenario in which the United States can avoid a technical bankruptcy for a couple of weeks by paying bondholders on the backs of other budget items such as social security and healthcare. Moody's Analytics would call this a breach of the debt limit. A breach of the debt ceiling is not as grave as a default. This would occur only if Treasury did not make a timely payment.
Brzeski stated that the markets would be still roiled, but this scenario would not cause 'the mother-of-all crises'. However, if a Treasury Security went into default that would cause 'immediate panic', noted Obstfeld from the Peterson Institute.
Moody's Analytics economists believe that if a breach lasted no longer than a week the US Gross Domestic Product (GDP) will decline by 0.7 percentage point and 1.5 million jobs will be lost. In a paper published this month, the authors assigned a 10% chance of a breach. They also noted that it would most likely be a brief one.
They wrote that if the political impasse continues through the summer and Treasury prioritizes debt payments above other bills, the 'blow to [the US] economy would cataclysmic'. GDP would plummet by 4.6% and 7.8 million jobs would be lost. Stock prices would plummet, wiping out $10 trillion of household wealth. Borrowing costs would also spike.
A severe recession in the United States caused by a prolonged breach, or a US default would also sink the global economic system.
If interest rates on US Treasuries spiked in either scenario -- and these rates are used to calculate the price of countless financial transactions and products around the globe -- borrowing costs would skyrocket everywhere. Credit markets would freeze and stock markets would plunge as a result of the financial panic.
Investors who buy Treasuries during times of crisis could sell them and switch to cash. When the last time this happened, in March 2020 when the coronavirus was spreading, the Federal Reserve took extraordinary measures to prevent a full-blown liquidation crisis.
The central bank lowered interest rates, bought bonds worth billions of dollars, offered large cash injections to banks and opened credit lines to foreign central banks to keep the dollar flowing throughout the global financial system.
The same measures could fall short, however, if creditworthiness is questioned.
Obstfeld stated that it was unclear whether the Fed would be able to do enough in the event of a Treasury default crisis, even if they used the same type of effort as in March 2020. It would take a larger effort to stabilize the markets, and this effort may only be partially successful...or not at all.
Neel Kahkari is the President of Federal Reserve Bank of Minneapolis and he's even more pessimistic. He told CNN's Poppy Hardlow that the Fed does not have the capability to protect the US against the negative effects of a default. He added that a default would send a signal to investors around the globe about eroding trust in America.
Dollar's Special Power
The dollar's damage could be minimal even if the confidence in the United States ebbs. In 2011, the dollar strengthened after the shock of S&P's downgrade prompted investors to rush for safe assets such as US Dollars.
Investors have few options in times of crisis, even if the crisis originates in the United States.
According to the Fed, between 1999 and 2019 the dollar represented 96% of all trade invoices in the Americas region, 74% of those in Asia-Pacific and 79% of those in the rest.
In 2021, greenbacks will make up 60% of the global foreign reserves disclosed. The majority of these reserves will be held as US Treasury bonds. Dollars are also the most dominant currency in international banks.
The argument for the dollar is that there are no other options. It's unclear where people will run.' Randy Kroszner said, former Fed Governor and economics professor of University of Chicago Booth School of Business.
The same argument can ultimately help support the $24 trillion US Treasury Market, which is orders of magnitude bigger than any other government bond market with similar creditworthiness.
Josh Lipsky is the senior director at Atlantic Council's GeoEconomics Center. He said: 'There are simply not enough safe assets for investors to switch from Treasuries.
Even if the dollar, and Treasuries are protected by their large role in international finance and trade, it doesn't mean that the fallout of a US default will not be severe.
Lipsky stated that even if US Treasuries had a short-term victory, everyone, including the US, would still lose in a default.