The government of the United States borrows money to meet its various financial obligations during periods of cash shortage. These include financing its operations, managing budget deficits, stimulating the economy during periods of economic downturns, funding long-term investments, and managing public debt through debt refinancing.
It is able to generate borrowed cash through the issuance of various types of debt securities or government bonds. The U.S. Department of Treasury manages this issuance through its Bureau of the Fiscal Service. Some examples of these securities include long-term instruments called Treasury Bonds and short-term instruments called Treasury Bills.
Most investors and analysts believe that lending cash to the U.S. through the purchase and holding of government bonds is a safe investment decision anchored on historical merit, the capabilities of government officials, its status as an economic powerhouse, and the favorable prospects of its economy. These securities have moderate to low risks.
The U.S. government has never defaulted on its debt obligations in its history. The risk of default is low. However, because all investments are not guaranteed, default is still possible under certain extreme circumstances. This minute likelihood still leaves some people wondering what would happen if the U.S. defaulted on its debt obligation
Exploring and Understanding the Potential Impact of a U.S. Debt Default: Consequences on the Domestic Economy and the Global Economy
The U.S. Debt and the Importance of the U.S. Treasury Market
The national debt of the United States is more than USD 31.40 trillion. About 78 percent of this debt is owed to the public which includes foreign governments, businesses, and individual investors while almost 22 percent represents intragovernmental debt or debt owed to other U.S. government agencies including Social Security and Medicare.
It is also important to note that the ratio of U.S. debt to its gross domestic product has been greater than 100 percent since 2012. This means that the national debt has become larger than the national economy and that the U.S. owes more money than it produces in a year.
The high level of U.S. national debt and its high debt-to-GDP ratio are a cause of concern for several economists. These two create uncertainties over the creditworthiness of the U.S. government and increase the risk or likelihood of default.
It is also important to underscore the fact that the U.S. is the largest borrower in the world. The U.S. Treasury market is also the largest and most liquid debt market in the world. It is also the backbone of the global financial system because it influences the value of the U.S. dollar. Take note that USD is the most extensively used currency around the globe.
Other financial markets are also reliant on the U.S. Treasury market. Changes in this market affect the specific performance of the stock market. It also serves as a benchmark for other financial assets or for determining other interest rates.
The aforementioned facts mean that a large number of entities or parties across the world composed of individual and institutional investors are holders of U.S. government bonds. These investors are exposed to risks associated with these bonds.
Specific Negative Macroeconomic Impacts of a U.S. Debt Default
A potential default would trigger a domestic economic crisis that would have a greater impact on the global economy because of the intricate role of the U.S. Treasury market in the global financial system. The following are the descriptions of interconnected factors that explain how a U.S. default on its debt would trigger a severe economic crisis:
• Higher Interest Rates and Increased Borrowing Cost: A government loses its credit rating when it defaults on its debt obligations. A lower credit rating translates to higher risk. This would result in investors demanding higher interest rates as compensation for the increased risk associated with investing and further higher borrowing costs for the government. The higher interest would affect other interest rates on business loans, mortgages, auto loans, and personal loans or consumer credit.
• Sell-Off of U.S. Treasury Securities and Capital Flight: Failure to meet debt obligations would erode the confidence of investors in the value of purchasing and holding U.S. Treasury securities or U.S. government bonds. This could further result in significant sell-offs in which investors would sell these bonds in the secondary market to minimize their exposure and manage the associated heightened default risk while also resulting in a capital flight from the U.S. financial markets.
• Damage to the Status of the U.S. Dollar as a Reserve Currency: The status of the U.S. dollar as the main reserve currency of the world partly rests on the stability and reliability of the U.S. government to fulfill its debt obligations. A default would undermine the established reputation of the U.S. dollar and can lead to a loss of confidence in the currency. This could weaken the ability of the U.S. to finance its deficits, result in a shift toward alternative reserve currencies, and disrupt international trade.
• Disruption to the Domestic and Global Financial Markets: Remember that the U.S. Treasury market influences other interest rates. It also serves as the foundation for several financial transactions across the different financial markets around the world. The same market is used as a benchmark for other financial assets. It is possible that a U.S. default would trigger a domestic financial crisis and a wider global financial crisis due to the position of U.S. Treasury securities in the global financial system.
Several scenarios would occur if the U.S. defaulted on its debt and when it lost its creditworthiness. Remember that the U.S. government is the largest borrower in the world and the U.S. Treasury market is the largest and most liquid debt market in the world. These facts mean that a default could lead to the following scenarios:
• Shutdown of Federal and State Government: A default would result in higher borrowing costs for the U.S. and further budget deficit. It would have a hard time raising funds further through the bonds market during periods of budget deficits due to its poor credit rating. This could lead to the cessation of selected government operations and projects while a prolonged inability to secure and raise borrowed cash would lead to a wider shutdown of government operations and functions.
• Contraction and Recession of the U.S. Economy: Another scenario arising from a U.S. default centers on different macroeconomic events in the U.S. economy. These include a possible stock market crash due to economic uncertainties, trade deficits due to depressed domestic production, weakened business activities because of capital flight and low revenues, higher unemployment and reduced consumer spending, and high inflation. These macroeconomic events would lead to an economic recession.
• Recession and Meltdown in the Global Economy: The U.S. is the largest economy in the world and its macroeconomic conditions have a significant global impact. The interconnectedness of the global financial system means that disruptions in one part of the system can quickly spread to other parts. This is called contagion effects. A U.S. default would trigger a domino effect that would affect different financial institutions worldwide and result in a broader economic crisis.
It is important to note that the actual degree of the aforementioned factors and scenarios that could occur from the U.S. defaulting on its debt obligations would depend on several factors. These include the size of the default, the length of the default, and the actions taken by the U.S. government and other countries in response to the default.