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How the effects of a US debt default would affect the world economy

The American economy wouldn't fall apart if the debt issue gripping Washington ultimately caused the country to enter a recession.
A first-ever government debt default would have far-reaching effects on the whole planet.
The United States' demand for electronics made in Chinese firms may decline. Swiss investors would see losses on their US Treasury holdings. Companies in Sri Lanka were no longer able to use dollars as a substitute for their own unstable currency.
If the US government went into default and the situation didn't get handled right enough, Mark Zandi, chief economist of Moody's Analytics, warned that “no corner of the global economy will be spared.”
The US economy would deteriorate so drastically and so quickly that 1.5 million jobs would be lost, according to Zandi and two of his Moody's colleagues, even if the debt ceiling were to be exceeded for just one week.
According to Zandi and his colleagues' analysis, the consequences of a prolonged government default would be much worse: US economic growth would slow, 7.8 million American jobs would be lost, borrowing costs would rise, the unemployment rate would increase from the current 3.4% to 8%, and a stock market crash would wipe out $10 trillion in household wealth.
Naturally, it may not even get to that. A round of debt-limit discussions between the White House and House Republicans ended on Sunday, with intentions to pick back up on Monday.
By refusing to increase the statutory borrowing cap, the Republicans have threatened to allow the country to fall into default if President Joe Biden and the Democrats do not agree to significant expenditure cutbacks and other concessions.
The fact that so much financial activity depends on faith in America's ability to always meet its financial commitments feeds the concern. Its debt, which has traditionally been seen as a very secure investment, is the cornerstone of world trade, which is based on long-standing faith in the US.
A default may destabilize the $24 trillion Treasury debt market, force financial markets to lock up, and spark a global catastrophe.
A debt default would be catastrophic, with unforeseeable but likely significant repercussions on the US and international financial markets. Eswar Prasad, senior fellow at the Brookings Institution and professor of trade policy at Cornell University, said.
The danger has arisen while a number of other concerns to the international economy are intensifying, including rising inflation and interest rates, the continuing effects of Russia's invasion of Ukraine, and the tightening grip of authoritarian governments. On top of all that, several nations have begun to doubt America's dominant position in international banking.
Political figures in the United States have often been able to increase the debt ceiling before it was too late by pulling back from the edge. Since 1960, the borrowing ceiling has been increased, altered, or extended 78 times by Congress, most recently in 2021.
However, the issue has become worse. After years of growing expenditure and significant tax cuts, partisan differences in Congress have deepened and the debt has increased. Treasury Secretary Janet Yellen has cautioned that if legislators don't increase or suspend the limit, the US may fall into default as early as June 1.
“If (Treasuries') credibility were to decline for any reason, the result would be a shock to the system,” Maurice Obstfeld, a senior fellow at the Peterson Institute for International Economics and a former IMF chief economist, said that these changes will have a significant impact on world GDP.
Treasurys are often utilized as loan collateral, as a safety net against bank losses, as a refuge during periods of extreme unpredictability, and as a storage facility for central banks' foreign currency reserves.
Treasury bills, bonds, and notes issued by the US government have a risk weighting of zero under international bank laws due to their perceived safety. 31% of the Treasurys in the global markets, or over USD 7.6 trillion, are held by foreign governments and private investors.
Since World War II, the dollar has effectively served as the de facto world currency due to its supremacy, making it very simple for the United States to borrow money and support an ever-rising mountain of public debt.
A strong dollar makes American products more expensive in comparison to their overseas competitors, which puts US exporters at a competitive disadvantage. However, increased demand for dollars also tends to make them more valuable than other currencies, which comes at a cost. That is one of the reasons the US has had annual trade deficits since 1975.
US dollars make up 58% of the total amount of foreign currency reserves maintained by central banks throughout the globe. The euro, at 20%, is second. The IMF estimates that the Chinese yuan accounts for less than 3%.
96% of commerce in the Americas was invoiced in US dollars from 1999 to 2019, according to Federal Reserve researchers. The same may be said for 74% of Asian commerce. Outside of Europe, where the euro predominates, 79% of commerce was conducted in dollars.
Because the dollar is so trustworthy, businesses in certain emerging markets prefer to accept payments in dollars rather than local currencies.
Take Sri Lanka, which has been severely affected by inflation and a precipitous decline in its currency. Shippers resisted releasing 1,000 cartons of critically needed food earlier this year unless they were paid in cash.
Because the importers couldn't find the cash to pay the vendors, the cargoes stacked up at the Colombo ports.
Speaking on behalf of the Essential Food Importers and Traders Association, Nihal Seneviratne stated, “Without (dollars), we can't execute any transaction). We must utilize hard cash, namely US dollars, while importing.
Similar to this, many stores and eateries in Lebanon, whose currency has fallen and inflation has raged, require payment in US dollars. Ecuador adopted the “dollarisation” process in 2000 in response to an economic crisis, replacing its own currency, the sucre, with dollars, and has continued to do so ever since.
Even when a crisis starts in the US, investors always turn to the dollar as their safe haven. When the US real estate market collapsed in late 2008, hundreds of banks and financial institutions were destroyed, including the once-powerful Lehman Brothers. As a result, the value of the dollar skyrocketed.
“Even though we, the United States, were the issue, there was still a flight to quality,” said Clay Lowery, the research director for the Institute of International Finance, a trade association for banks. “The buck is king,”
The dollar would climb once again, at least initially, “because of the uncertainty and the fear,” according to Zandi, if the United States exceeded the debt ceiling without settling the disagreement and the Treasury stopped making payments. Global investors just wouldn't know where else to turn but the United States, where they usually go in times of crisis.
However, the Treasury market would probably be shut down. Instead of stocks, investors can switch to US money market funds or prestigious US company bonds. Growing skepticism, according to Zandi, would eventually reduce the value of the dollar and keep it low.
Lowery, who was an assistant Treasury secretary during the 2008 crisis, envisions that the United States will continue to pay interest to bondholders in the event of a debt-ceiling crisis. Additionally, it would make an effort to settle its other debts, such as those owed to retirees and contractors, in the order in which they were due and with the available funds.
The government may pay debts that were due on June 3 on June 5, for instance. Around June 15, there would be some reprieve. Government income would swell at that time as many taxpayers made their second quarter anticipated tax payments.
Those who weren't being paid — “anybody who lives off veterans' benefits or Social Security,” according to Lowery — would probably file lawsuits against the government. Even if the Treasury kept paying interest to bondholders, ratings agencies would probably lower US debt.
Even while the dollar still rules the world, it has recently lost some ground as more banks, companies, and investors have shifted their investments to the euro and, to a lesser degree, the Chinese yuan. Other nations often dislike how fluctuating dollar values might harm their own national currencies and economy.
By deterring investment from other nations and increasing the cost of debt repayment in dollar terms, a rising dollar may lead to problems overseas. Some other nations are uneasy about the United States' willingness to utilize the dollar's influence to inflict financial penalties on competitors and enemies.
But no obvious alternatives have yet surfaced. The dollar is well ahead of the euro. Even more so does China's yuan, which is constrained by Beijing's unwillingness to permit free exchange of its currency on international markets.
However, the drama around the debt limit is certain to raise further concerns over the huge financial strength of the United States and the currency.
Obstfeld said, “Right now, the world economy is in a really precarious position. Therefore, it is quite irresponsible to add a problem about the creditworthiness of US liabilities to the mix.

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