Why is it necessary to raise the debt ceiling? 2:19
London (CNN) -- The world economy has suffered two major shocks in three years. It could be about to suffer a third because of the US debt crisis.
Following the covid pandemic and Europe's first major war since 1945, the specter of the US government's inability to pay its bills now haunts financial markets.
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For most, it is unthinkable, perhaps because the consequences are terrifying. And it may never happen: On Friday there were signs that negotiations in Washington to increase the amount the U.S. government can borrow were gaining momentum. But if it happens, the 2008 global financial crisis might seem like nothing.
The consequences of a default would be "a million" times worse, said Danny Blanchflower, an economics professor at Dartmouth College and a former interest-rate setting official at the Bank of England. "What if the world's biggest economic monolith can't pay its bills? The consequences are terrifying."
The belief that the U.S. government will pay its creditors on time underpins the smooth functioning of the global financial system. It makes the dollar the world's reserve currency and U.S. Treasuries the foundation of bond markets around the world.
"If the credibility of the Treasury's payment commitment is called into question, it can wreak havoc on a whole range of global markets," said Maurice Obstfeld, a nonresident fellow at the Peterson Institute for International Economics, a Washington think tank.
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During the 2011 standoff over the rising U.S. debt ceiling, the S&P 500 index of major U.S. stocks plunged more than 15%. The index continued to fall even after a deal was reached, which came just hours before the government ran out of funds.
So far, stock markets have dismissed a potential default, even as the so-called June 1 X date approaches. That's when the government, unable to borrow more, could run out of money, according to Treasury Secretary Janet Yellen, who continues to believe a deal will be reached in time.
"One of the concerns I have is that even in the run-up to a deal, when it happens, there can be substantial distress in financial markets," he said Wednesday.
Fitch has already put the U.S. triple-A credit rating, its highest score, on watch for a possible downgrade due to risky policies.
The move brought back memories of 2011, when S&P downgraded the U.S. rating from "AAA" to "AA+." More than a decade later, S&P still hasn't restored that perfect credit rating.
Any downgrade, however small, affects the price of trillions of dollars of US government debt and causes future borrowing costs to rise. Yields on short-term Treasuries have already risen and U.S. mortgage rates have soared amid the uncertainty.
From bad to worse
There is no historical precedent for a default in the US, which makes it impossible to predict how it would develop and makes it difficult for institutions to prepare.
This was revealed this week by the director of one of the largest lenders in the world. World Bank President David Malpass told CNN's Julia Chatterley that the institution did not have "a special war room" to manage the threat. "I don't expect a default," he added.
That "war room" does exist at JPMorgan Chase. CEO Jamie Dimon told Bloomberg earlier this month that the bank was holding weekly meetings to prepare for a possible U.S. default and hoped to meet daily by May 21.
For Carsten Brzeski, global head of macroeconomic research at the Dutch bank ING, there can be no "automatic reaction" to this catastrophe.
In a scenario outlined by Brzeski, the United States could avoid a technical default for a few weeks if it continued to pay bondholders at the expense of other budget items, such as spending on social security and health benefits. That would be what Moody's Analytics calls a "default" on the debt ceiling. A default is not as serious as a default, which would only occur if the Treasury did not make a payment on the debt on time.
In that case, markets would remain choppy, but it would not trigger "the mother of all crises," Brzeski said.
- Social Security payments in the US could be delayed by the stagnation of the debt ceiling
But default on a Treasury security would trigger "immediate panic in the markets," said Obstfeld of the Peterson Institute.
Economists at Moody's Analytics believe that even in the event of a default lasting no more than a week, U.S. gross domestic product (GDP) would shrink by 0.7 percentage points and 1.5 million jobs would be lost. In a paper published this month, they assign a 10% probability to a default, adding that it is most likely brief.
If the political stalemate drags on into the summer, with the Treasury prioritizing debt payments over other bills, "the blow to the [U.S.] economy would be cataclysmic," they wrote. GDP would fall by 4.6%, costing 7.8 million jobs. Stock prices would plummet, wiping out $10 trillion of household wealth, and borrowing costs would skyrocket.
A deep recession in the United States, triggered by a prolonged U.S. default or default, would also sink the world economy.
In any of those scenarios, if interest rates on U.S. Treasuries, which are used to price countless financial products and transactions around the world, were to skyrocket, borrowing costs would skyrocket everywhere. Financial panic would lead to the freezing of credit markets and the collapse of stock markets.
Investors, who traditionally buy Treasuries in times of crisis, could ditch them and turn to cash. The last time that happened, when the coronavirus pandemic was unfolding in March 2020, the Federal Reserve had to take extraordinary measures to avoid a full-blown liquidity crisis.
He slashed interest rates, launched a massive bond purchase worth billions of dollars, offered huge cash injections to lenders, and opened lines of credit for foreign central banks in order to keep dollars flowing through the global financial system.
The U.S. Treasury Building in Washington. Credit: Ken Cedeno/Sipa USA/AP
But the same measures may fall short if the solvency of the U.S. government is in question.
"It's not clear in a Treasury default crisis whether the Fed could do enough even with the kinds of efforts it deployed in March 2020," Obstfeld said. "It would take a much greater effort to stabilize the market, and that effort may well be only partially successful... or not be very successful at all."
Neel Kashkari, president of the Federal Reserve Bank of Minneapolis, is even more pessimistic. The Fed does not have "the ability to protect the U.S. economy from the downside of a default," he told CNN's Poppy Harlow this week. "A default would be a message to investors around the world of eroding confidence in the United States."
The special power of the dollar
Even if confidence in the United States evaporates, the damage to the dollar could be limited. In 2011, the currency strengthened when the S&P downgrade led investors to take refuge in safe haven assets, such as the dollar.
The currency's preeminent role in the global economy leaves investors with few alternatives in the event of a crisis, even when that crisis comes from the United States.
Between 1999 and 2019, the dollar accounted for 96% of trade turnover in the Americas, 74% in the Asia-Pacific region and 79% in the rest of the world, according to the Fed.
The greenback accounted for 60% of foreign exchange reserves disclosed globally in 2021, most of which are held in the form of US Treasuries. The dollar is also the dominant currency in international banking.
"The argument for [the dollar] is that there's really nowhere else to go... It's not clear exactly where people are running," said Randy Kroszner, a former Fed governor and now an economics professor at the University of Chicago's Booth School of Business.
Ultimately, the same argument could help prop up the $24 trillion U.S. Treasury market, which is an order of magnitude larger than any government bond market of similar creditworthiness.
"There simply aren't enough safe assets available for investors to dump Treasuries," says Josh Lipsky, director of the Atlantic Council's Center for Geoeconomics.
But even if the dollar and Treasuries enjoy some protection by virtue of their dominant role in international trade and finance, that doesn't mean the consequences of a U.S. default aren't serious.
"The bottom line," Lipsky said, "is that in a default, even if U.S. Treasuries gain in the short term, everyone — including the U.S. — will continue to lose."
-- Robert North contributed to this report.