The United States is currently facing the potential risk of a debt default, and while it may not be an immediate “nightmare,” a scenario of defaulting on its government debt for a prolonged period could have significant economic and reputational consequences. This article delves into the possible outcomes of such a situation and the implications it would have on the global economy.
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The Clear Path to US Debt Default
If the current debt ceiling of $31.4 trillion is not raised by around June 1st, the US government will run out of cash to cover various expenses, including military salaries, federal employee wages, and bond interest payments. While the US has faced similar deadlines in the past, this time the political landscape is more challenging, making it harder to reach a resolution.
Political Challenges and Potential Scenarios
House Speaker Kevin McCarthy aims to implement substantial spending cuts, aligning with the Republican Party’s principles. Meanwhile, President Joe Biden risks losing support from Democratic party members if he compromises too much on Republican demands. The Treasury Department and the Federal Reserve have contingency plans in place if the debt limit is not raised. Referred to as “payment prioritization,” they would prioritize using available funds to meet bond interest payments and reduce other expenditures.
However, prioritizing bond payments over employee wages or retirement benefits may not be sustainable, and the daily race to meet bond obligations is far from ideal. Such a dysfunctional government raises doubts among investors, eroding trust in the US government’s ability to manage its financial affairs.
Short-Term Crisis or Long-Term Catastrophe
According to The Economist, the US debt default could result in either a short-term crisis or a long-term catastrophe. While both scenarios would be detrimental, the long-term scenario would be far worse. The US is the largest holder of public debt globally, with $25 trillion in bonds held by the public. Its bonds are considered risk-free assets, providing guaranteed returns to investors, and serving as a benchmark for pricing other financial instruments.
The US Treasury bond market serves as the foundation of daily cash flow. The short-term repo market, with a scale of around $4 trillion daily, is crucial for the global financial system. It relies on using US Treasury bonds as collateral. All of this would become unstable in the event of a US debt default.
Short-Term Default Scenario
In a short-term default scenario, the Federal Reserve would handle defaulted securities, such as bonds with missed interest payments, similar to regular securities, accepting them as collateral for central bank lending or potentially repurchasing them. They could also exchange them with investors, receiving “bad debt” in return and issuing “good debt,” assuming that the government would eventually fulfill its obligations, albeit with delays.
While Fed Chairman Jerome Powell described such actions as “distasteful” in 2013, he also acknowledged the possibility of accepting them under certain circumstances. Although the Fed is cautious about getting involved in political disputes and conducting fragmented fiscal and monetary policy actions, it would likely consider such measures to prevent financial turmoil if a default were to occur.
A few days of default would be damaging to the US reputation and could trigger a recession. Moody’s Analytics estimates that immediately following a default, the US economy would contract by nearly 1%, and unemployment rates would rise from 3.4% to 5%, resulting in approximately 1.5 million job losses. However, with careful management, it may not turn into a full-blown nightmare.
Long-Term Default Scenario: A prolonged default due to Congress’s failure to promptly raise the debt ceiling would be even more dangerous. Economist Mark Zandi compares it to the critical moment of the Troubled Asset Relief Program (TARP) in the autumn of 200