The impact could be large and global, as Christine Lagarde points out in this article.
“Frankly, to have a default, to have a serious downgrading of the United States’ signature would be a very, very serious event,” said Ms. Lagarde at a meeting of the Council on Foreign Relations in New York. “Not for the United States alone, but for the global economy at large because the consequences would be far-reaching. It would not stop at the frontiers of the United States; it would go beyond.”
[…]
If the US were to default on the interest on its bonds, private economists say, it would cause banks around the world to write down the value of their enormous holdings of US Treasury securities. At the same time, stock markets around the world would probably plunge.
“That would have a devastating effect,” says Jay Bryson, international economist at Wells Fargo Economics Group in Charlotte, N.C.
If banks were to write down the value of their bonds, they would have to raise capital quickly or shutter their doors, Mr. Bryson says. “Their capital base would shrink, and when that happens, they are less likely to make loans,” he says. “It would spill over very quickly to the real economy.”
In the past I’ve argued that one of the reasons why we have anemic economic growth has been regime uncertainty. The idea is that during a crisis politicians see opportunities to push through policies and legislation they’d not be able to get through during non-crisis periods. This in turn exacerbates the uncertainty many see in the economy, not reducing it. This in turn can lead to less investment than there otherwise would be and that in turn could lower economic growth.
The above description of a U.S. default is something that would increase uncertainty and reduce investments in a way that we have not seen since probably the Great Depression. And it is indeed tied to our current economic/financial crisis. The Tea Party wing of the Republican party is enjoying increased power due precisely to the crisis and the higher debt levels such crises always bring about.
Of course the U.S. could simply decide to fall on its own sword,
Nariman Behravesh, chief economist for IHS Global Insight in Lexington, Mass., says the Federal Reserve would step in to stabilize the financial markets.
“I suspect the Fed already has contingency plans for this problem,” Mr. Behravesh says. “It does not necessarily have to be a disaster.”
The US Treasury would continue to pay the interest on US debt, he says. However, he estimates that the government is spending 40 percent more than it’s taking in. This means the government would have to stop paying other bills coming due.
“We would have to slash paying for Medicare, issuing Social Security checks. That would kill the economy,” Behravesh predicts.
I don’t think many who advocate such massive and draconian cuts to Medicare and Social Security appreciate is the impact on the U.S. economy. In May of this year the federal government spent $233 billion, 40% of that is around $93 billion. That would have a pretty significant impact on the U.S. economy. I’m all for getting our fiscal house in order, but that is absolutely not the way to do it.
“To be precise, our studies show that a reduction of one percentage point on the deficit entails in many instances 0.5 percent off the growth number,” she enumerated. That’s why, she said, the IMF recommends any budget cutting take place at a time when the economy is growing.
Bahravesh, for one, says Congress should postpone major spending reductions for at three to four years. “It’s a bit of a balancing act. We think you want to backload it versus starting it next year,” he says.
Part of me agrees with this. Cuts right now are probably not a good idea. At the same time neither are tax increases. But at the same time whatever budget/debt ceiling agreement is reached must be seen as credible. That has often been the problem with many of these budget proposals. “My budget proposal will cut the deficit by x% in 10 years!” Problem is it rarely happens. Yeah, yeah, I know Bill Clinton…like I said rarely happens.
If the rating agencies downgrade US bonds, it might have a negative impact on some money-market mutual funds and insurance companies whose standards require them to invest in the highest-rated bonds. But it might not be disastrous, Bahravesh says.
“What are the alternatives?” he asks. “Where do money-market funds and insurance companies go? Do they buy Chinese bonds or German bonds? There are no good alternatives.”
Basing policy on hoping for the best strikes me as not very good policy.
