Arshad Mahmud

What happens if the US defaults?

July 28, 2011
People hold signs as dozens of Tea Party supporters rally near the U.S. Capitol against raising the debt limit in Washington, July 27, 2011. Photo: Reuters

People hold signs as dozens of Tea Party supporters rally near the U.S. Capitol against raising the debt limit in Washington, July 27, 2011. Photo: Reuters

As you’ve already noticed, the whole world is now focused on what happens on Aug 2 when the deadline for raising the United States current debt limit of $14.3 trillion expires. Tension is mounting all across largely because what happens in the world’s largest economy has implications for many countries including Bangladesh, which exports bulk of its readymade garments to the country.

With less than a week to go, the obvious question is whether the Republican and Democratic leaders in Congress would be able to strike a deal before Aug 2 so that the US can avoid defaulting on its debt payment.

By all indications, Congressional leaders would be forced to make a deal given the rising voters’ anger against the increasingly dysfunctional way Washington works. Recent polls show Americans are getting fed up with both Democratic and Republican Congressional leaders, as well as President Obama for their seeming inability to put their acts together.

Before I get to the disastrous impact of a default on the US economy, let me explain briefly what the debt ceiling means.

Debt ceiling is the legal limit on the amount of money the US government can borrow to pay its bills, which includes the salaries of federal employees, federal programs such as Social Security and Medicare (a health insurance program for the elderly), and principal and interest payments to bondholders.

The obvious question is why President Obama can’t raise the debt limit through an executive order. The answer is: he cannot do so even if he’s considered the most powerful man under the sun.

Under the US constitution, only Congress can authorise the federal government to borrow money. Since 1962 Congress has raised the debt ceiling 72 separate times, including 10 times in the past decade alone.

A rule adopted in 1979 had allowed the House of Representatives to automatically raise the debt limit to whatever level the budget required. But in January 2011, the House voted to repeal this rule, requiring the House to hold a separate vote to increase the debt limit.

When Obama took office in January 2009 in the midst of the biggest economic downturn since the Great Depression, US public debt stood at $10.6 trillion. This May, two and a half years later, the current debt limit of $14.3 trillion was reached.

Most analysts say that even after August 2, the Obama administration has some flexibility to continue meeting their payments at least for a few more days. Federal Reserve chairman Ben Bernanke has said that after August 2, the Treasury will prioritise payments on federal debt.

You may wonder why the world’s richest country needs to borrow so much money from foreign governments like China, Japan and Saudi Arabia.

The answer is simple. For many years now, the US imports much more than it exports, leaving a huge deficit in its balance of payment. No wonder, it needs to borrow money to finance its expenditure. The deficit kept growing over the years for many reasons including the wars in Iraq and Afghanistan.

In the wake of the financial crisis of 2008, the government spending soared when bailout and stimulus bills were passed in efforts to rescue and reinvigorate the US economy. Meanwhile, the recession caused tax revenues to slump. With less revenue and more expenses, the deficit grew. To meet these shortfalls, the US government borrowed more money, adding to the national debt.

The problem goes back further, though. In 2001 and 2003 George W. Bush signed into law tax bills that lowered the top marginal income tax rate from 39.6 percent to 35 percent, and slashed the top capital gains tax rate from 20 percent to 15 percent. As a result, according to a USA Today analysis, the percentage of income that Americans are paying in taxes is at its lowest level since 1950.

Meanwhile, the wars in Afghanistan and Iraq swelled the deficit. Health care is another big cost: The amount that the US government spent annually on Medicare increased by 137 percent from 1999 to 2009. According to the US treasury, the national debt has risen by more than $500 billion each year since 2002.

Now let me explain the looming disaster that can befall the US and the global economy in the event of a default.

The other day, US treasury secretary Timothy Geithner said that if the US ends up defaulting for the first time in modern history, the effect will be “catastrophic.”

The rates on US treasury bonds would spike, making it more expensive for the US to borrow money in the future. And since US bond yields serve as a floor for other lending rates, local governments and US corporations would find it more expensive to borrow money, and Americans would have to pay more to service their mortgages.

But since the US is the world’s biggest economy, the implications of a default could be equally grave in international markets. Because the global money market — a short-term loan market used by businesses around the world to finance their operations — often requires assets to be backed by US treasury instruments, a US bond default could cause this market to freeze up, as it did in September 2008 when Lehman Brothers collapsed.

Finally, the US dollar would almost certainly decline in value.

The looming disaster is sending shockwaves through the markets all over. Major rating agencies have already begun sounding alarm bells. On July 15, Standard & Poor’s warned that it could cut the US’ coveted AAA credit rating if no deal is done, which could limit some investors’ ability — and willingness — to lend to the US government. Even if the US does continue to pay bondholders, if investors refuse to buy US bonds, that could cause panic on the markets, forcing a default.

At this point, it seems highly unlikely that any budget deal will include substantial tax revenue increases. Instead, spending cuts will comprise a much larger part of a deal.

The US economy remains anaemic, with unemployment hovering above 9 percent. Although the US stock market has recovered strongly since its nadir in March 2009, wages have not risen, and consumer spending remains weak.

And that is the biggest concern for countries like Bangladesh, which depends heavily on exports to the US market. Just think of the scenario in which Americans are forced to tighten their belt and stop purchasing shirts and trousers. In that event, Bangladesh garment industry will take a direct hit.

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Arshad Mahmud is a Washington Correspondent for bdnews24.com.

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3 Responses to “ What happens if the US defaults? ”

  1. M. Haque on July 29, 2011 at 12:59 am

    These hyped-up talks of ‘debt ceiling’ are talks of sky falling by Chicken Little. The US remains, at least for now, the largest economy whose bonds others consider the safest haven. Even if the US defaults, the US bonds will continue to be sought and irrespective of credit ratings, market forces will determine the interest rates. With the crisis in Europe where the Euro-zone future is shaky, will Euro bonds be sought? With the voracious appetite for US consumers to buy cheap junks from Far-East, the sovereign bond holders will be more than willing to buy US treasuries to keep their economy going.

    It is all because of the vicious cycle of free (not fair) trade agreements. The credit rating agencies and financial institutions have lots to gain from raising the debt ceiling. They will be the biggest beneficiaries. The banks will be taking a charge against their fat profits and hence this hype of ’sky falling’.

    Ignore the warnings from credit rating agencies. Aren’t they the ones who were peddling the sub-prime mortgages as safest investment a few years back? Their actions have been irresponsible and maybe bordering on criminal mischief.

  2. Golam Arshad on July 28, 2011 at 9:49 pm

    Arshad: The deal will be struck soon! The symbiotic notion of check and balance will be triggered in, mighty dollar “In God we Trust” will creep up and the world economy will take a breather! That’s my view! President Obama most likely will be reelected.

    • M. Haque on July 29, 2011 at 9:26 pm

      The biggest gainers from this fiasco will be the financial institutions and that’s why we hear all this talk of ‘Chicken Little’s’ – sky is falling. Banks and financial institutions do not want to see a cut in their fat profits. US remains the largest economy and these veiled threats of rating downgrade are all hyped up. US treasuries remain the safest investment – given that Euro zone has its troubles that are more than what we have. Do you think Chinese and ME nations will go for Euros or Metals and not opt for US treasuries? The Chinese know that unless they buy US bonds, their imports (fuelled by voracious appetite for US consumers for junk items) are going to slow down and so will their economies. Let us all see the fruits of free (and not fair) trade. Who cares about credit downgrade? US treasury auction will be called off – if we find the yields unattractive.

      During last financial bailouts – we heard all these talks of impending catastrophe. Let us face it for real one time and sort out whose shots are for real. I, for one, do not put any value to calls from rating agencies. Were these not the same people that were selling us the sub-prime mortgages? Their actions are downright mischievous – bordering on criminal negligence.

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