US Treasury Secretary Janet Yellen’s recent warning about the fallout from a US debt default is sounding alarm bells about the stability of the global economy and finance. As things stand, the country is about to slam into its debt ceiling of $31.4 trillion with few countermeasures in hand.
The main driver of the crisis has been unrestrained spending by the US government that experts attribute to the hegemony of the US dollar. Its status as the world’s reserve currency fed the excessive issuance of banknotes, which in turn fuelled a significant increase in the US government’s debt.
Default as early as next month
On Monday, the US Treasury secretary warned that the government could default on its debt as early as June 1 if Congress failed to raise the debt ceiling in time.
“With additional information now available, I am writing to note that we still estimate that the Treasury will likely no longer be able to satisfy all of the government’s obligations if Congress has not acted to raise or suspend the debt limit by early June, and potentially as early as June 1,” Yellen wrote to House Speaker Kevin McCarthy, according to reports by US media outlets.
At the time of writing, US President Joe Biden was locked in discussions again with a panel of Congressional leaders, including McCarthy, to raise the nation’s borrowing limit. The meeting happened as the White House announced it was ‘reevaluating’ some of Biden’s foreign trip stops in light of the crisis.
What comes after default?
Within the US, the debate around the debt ceiling has largely revolved around gaining leverage for the upcoming general election.
Global experts and observers, however, are warning that the crisis should not be underestimated. Repercussions in the event the US government does default would be severe.
Experts have suggested several short-term consequences that could materialise, including the downgrade of treasuries, increased borrowing rates for consumers, corporations, and the government, a potential sell-off of dollar-denominated assets by global investors, depreciation of the US dollar in foreign exchange markets, and a significant decline in stock markets.
Moreover, the overload on the financial system’s infrastructure, such as the central counterparty clearing house, could lead to its collapse if everyone attempts to close their positions simultaneously.
The long-term implications of a US debt default are equally concerning. The collapse of the dollar’s status as the global ‘unit of account’ for trade could occur, leading to the replacement of the dollar with other currencies.
Currently, over half of world trade is settled in dollars, granting the United States the ability to pay its foreign debts in its own currency. This dominance affords American companies a competitive advantage in international trade and finance, shielding them from currency risks faced by foreign competitors. If the dollar loses its status, American economic privileges and its capacity to influence global affairs could diminish significantly.
Even the increased risk of default on US debt can negatively impact the economy. Protracted disagreements on raising the debt ceiling could result in stock market declines of nearly 20%, a contraction of more than 4% in the economy, and the loss of over seven million jobs, as projected by Moody’s Analytics.
The current US debt burden, excluding future welfare expenditures, has the potential to approach a staggering $200 trillion, according to billionaire investor Stanley Druckenmiller.
The US debt ceiling crisis could also further destabilise the country’s banking sector. As the risk of default looms, financial markets face increasing volatility.
Higher interest rates on US bonds, triggered by the debt ceiling debate or investor concerns about default, could reduce the value of outstanding bonds. This, in turn, would impact the capital reserves of banks, making it difficult for them to meet depositor demands and potentially leading to bank failures.
Small and medium-sized banks are particularly vulnerable, with the potential for a ‘doom loop’ or ‘death spiral’ as deposits dwindle and debt costs rise.
The Fed’s dilemma
The Federal Reserve now finds itself in a dilemma of protecting the US dollar or the banking system. While the Fed has chosen to prioritise the dollar’s stability, the impact on US banks threatens to be severe regardless of size.
Large US financial institutions already hold book losses of $210 billion on US treasury bonds, and if interest rates and inflation persist, these losses may become real and trigger significant turmoil within the financial sector.
In conversation with China’s Global Times, international finance expert and Taihe Institute researcher Zhang Chao said even if the Federal Reserve chooses to protect the credit of the US dollar, the decline of the currency’s hegemony is almost inevitable.
“Since commercial value is an important manifestation of the US dollar’s hegemony, when that commercial value is damaged, the dollar’s hegemony will also be damaged,” the expert was quoted as saying.
