Happy X-Day

Dueling duo: President Joe Biden and House Speaker Kevin McCarthy. Photo: Drew Angerer, Getty Images

Welcome to Apocalypse, population eight billion.

The United States government is virtually at its legal limit on debt. Without a higher limit, or lower spending, the government will not be able to pay its bills.  Democrats want to borrow more; Republicans want to spend less. If they don't agree in a few weeks, the government may default on its debt. Talks between Biden and McCarthy are going nowhere fast.   

Suppose that the US does default. What next?

As default approaches, investors will sell their US government bonds before they become mere paper.  Bond prices will fall, so interest rates will rise. (The interest rate is usually the ratio of a fixed payment to the bondholder, relative to the bond price. When the price falls, the interest rate rises.) The fix is already in: The figure below shows that interest rates rose sharply over the past week on a government note that matures in two years. Investors think that default would affect the economy for years.

Higher interest rates will discourage borrowing. Automakers will cancel plans for new assembly plants.  Households will cancel plans to vacation at the Grand Canyon (especially since the parks will shut down, anyway).  Spending will fall.  Recession may beckon.

That’s not all. The banks earn some of their money from the bonds they hold. When interest rates rise, these bonds will lose value, because they pay off at lower rates than current bonds. The banks will have trouble selling these bonds to earn cash to cover withdrawals from their deposits. Uninsured depositors know this, so they will pull out their money right away. The banks will face runs, just as did Silicon Valley Bank and First Republic.

Default may also stoke US inflation.  If the government defaults, or even just comes close to it, investors won’t want so many dollars, because they won’t want to buy US bonds. They will exchange dollars for euros and renminbi. The exchange rate of dollars for a euro will rise. So the dollar price of European imports into the US, which have a fixed euro price, will rise. For example, if a Belgian chocolate sells for one euro (I wish), and the exchange rate goes from one dollar per euro to two dollars, then the price of a chocolate import will rise from $1 to $2.  In general, the prices that Americans pay will rise.so thar 

And don’t forget the world economy. The US dominates global financial markets. When its interest rates rise, so do rates around the world. Global borrowing may fall, cutting income and threatening recession.  Small poor nations that must borrow to survive, like Kyrgyzstan, may not be able to afford rolling over their loans.

Finally, the shock of default by the nation most famous for paying its bills on time may touch off sea changes in global financial markets. Investors will lose confidence and invest less.  Households will find it harder to obtain long-term loans for college and homes. Governments, and international organizations like the World Bank and the United Nations, won’t be able to plan, because they won’t know how much they will have to pay for a loan that builds hospitals in Syria and Sudan.

Dunking the dollar

Central Asia is especially at risk, because it relies on the dollar for stable trade.  The dollar is everywhere, and everyone trades in it. So when one small country sells to another, it normally exchanges via the dollar.  For example, suppose that Kazakhstan wants to sell wheat to Botswana. The tenge and the pula are minor currencies, so the market in tenge-pula exchanges is thin and subject to wild fluctuations in the exchange rate. It is easier and cheaper to exchange pula for dollars, and then dollars for tenge, than pula for tenge directly.

Now suppose that debt default undermines the dollar.  Then it may no longer be ubiquitous, nor its exchange rate reliable.  It may no longer serve as an easy intermediary in tenge-pula trades.  The Botswana market for Kazakhstani wheat may vanish.

Of course, there are other vehicle currencies — the euro, the yen, the renminbi.  But none is so widely used as the dollar. 

Most folks seem to think that the White House and the House of Representatives will pull back from the precipice at the last minute, as in 2011. But financial markets are more computerized today and may react to the threat of default faster than the government expects. The figure above suggests that investors already are dumping government bonds. Why would they wait until they're worthless? And government agencies may spend more rapidly as X-date approaches to avoid a cutoff by the executive branch. Treasury may run out of cash sooner than it thinks. In short, the very belief in a last-minute solution may block it.

Would everybody lose from US default?  No. As the relative demand for US bonds falls, the relative demand for other bonds will rise.  Investors will exchange American bonds for Chinese ones. But even the Chinese will lose to the extent that they hold trillions of dollars of US assets.

The biggest question: How will the government operate after default? The most sensible course would be to pay creditors first and cut back other spending so that tax revenues can cover it. This would partly salvage America's financial repute. But it means paying rich Chinese and Saudi investors before poor Americans. Not the greatest optics.  

What's left?  Since the government lacks time to plan in detail, it may simply cut spending across the board. The most valuable services may take the same relative hit as the least. The resulting chaos could pave the way for hostile operations: Russian troublemaking in the social media, Iranian harassment of the small American force in Syria.    

Just when you thought it was safe to go back into the water… — Leon Taylor, Baltimore, tayloralmaty@gmail.com