It’s hard to imagine how the United States could inflict more harm on itself than by defaulting on its debt. Yet that is exactly what will happen later this month if Congress refuses to lift the country’s debt ceiling.
The United States is the world’s only superpower in large part due to its ability to buy things from other counties on credit – or, more precisely, in exchange for US government bonds back, not by gold, but merely by the “full faith and credit of the United States government.” If Congress forces the government to default, that faith will evaporate – and so will the country’s superpower status. The day the rest of the world loses its confidence in the United State’s willingness to pay interest on its debt is the day the US will cease to be a superpower. That day will also mark the beginning of a New Great Depression.
The United States government has the ability to pay its debts. This default crisis is only a matter of the willingness of Congress to allow the government to pay them. The debt of the US government is approximately $16 trillion. That is roughly the same size as the US economy. In other words, US government debt is approximately 100% of US GDP. Japan’s government debt is nearly 250% of Japan’s GDP. That suggests the US government could borrow another $24 trillion before the ratio of US government debt to GDP reached the ratio of Japanese government debt to GDP – even if the US economy did not grow at all!
Investors are willing to lend the US government money for 10 years at an annual interest rate of 2.6% (the yield on the 10-year government bond). That rate is significantly below the government’s average cost of borrowing over the past 50 years. This shows the US government is nowhere near having a genuine debt crisis. And, by the way, the Japanese government can borrow money for 10 years at an annual interest rate of only 0.7%, despite having a ratio of government debt to GDP that is two-and-a-half times higher than that of the United States.
A third fact to keep in mind is that the US government’s budget deficit is already contracting very sharply this year – too sharply for the wellbeing of the global economy according to an IMF report released this week. The budget deficit is due to shrink 40% this year, from $1.1 trillion in 2012 to $640 billion in 2013. This huge reduction of the budget deficit is already acting as a severe drag on US economic growth. Any further cutbacks in government spending in the near term would almost certainly throw the economy back into recession.
But a recession would feel like a bed of roses compared with the Great Depression that would be caused by a Congressional decision to default on the United States’ debt. A default of even a few days would do terrible harm, but a default that lasted any significant length of time quite possibly could cause a global economic breakdown from which there would be no escape.
Since 1971, the United States has enjoyed the unique privilege of being able to buy things from other countries using paper dollars or bonds denominated in paper dollars as payment – and there was practically no limit as to how many paper dollar the United States could create. Should Congress refuse to allow the US government to pay its debts, the rest of the world will stop extending credit to the United States and that privilege will be destroyed. If that occurs and the Dollar Standard collapses, the consequences could be catastrophic. Here is one possible scenario:
With all foreign funding cut off, interest rates in the US would soar – not only the interest rates on government debt, but also the interest rates on mortgages and consumer credit. Home prices and retail sales would crash. That would only be the beginning.
US exports would plunge. When the rest of the world stopped accepting the United States’ IOUs in exchange for their manufactured goods, their factories would close for lack of buyers and their economies would collapse, leaving them with no means to buy anything from the United States.
Consequently, unemployment would skyrocket around the world and trade barriers would go up everywhere (as they did during the 1930s). That would be the end of Globalization.
Trade barriers and protective tariffs would radically drive up the cost of goods imported into the Unites States, and that would fuel another round of inflation, higher interest rates, asset price deflation and rising unemployment.
In all probability, the banking system in the US (and just about everywhere else) would fail. Everyone’s bank deposits would be destroyed. The US economy would collapse. It is unlikely that this generation would live long enough to see the recovery.
Congress faces a choice. It can honor the government’s debts as it has always done in the past or it can refuse to honor them and risk destroying the global economy. This really should not be a difficult decision.