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Could a US Debt Default Unleash Global Chaos?

The US government is currently engaged in what could be one of the most costly games of chicken in history.

If Democrats and Republicans do not agree to allow the US to borrow more – or, in their language, raise the debt ceiling – the world’s biggest economy will default on its $31.4 trillion (£25tn) debt.

They have to reach an agreement by the ominous sounding “X-date” of 1 June.

But if they don’t, what could that mean for other countries – and you?

The economy will slow

First things first: all the experts the BBC spoke to do not think the US will default on its debt.

However, if it did, “it would make the global financial crisis look like a tea party”, says Simon French, chief economist at investment bank Panmure Gordon, referring to the near collapse of the world’s banking industry in 2008.

If the US does not lift its debt ceiling, it will not be able to borrow more money – and it will quickly run out of funds to pay for public benefits and other obligations.

“It would stop doling out welfare payments and support to people, which would hit their ability to spend and pay their bills,” says Russ Mould, investment director at AJ Bell. “So it would therefore hit the economy.”

The White House Council of Economic Advisers estimates that if the government cannot reach a debt ceiling agreement for a prolonged period, the economy could shrink by as much as 6.1%.

Economist Mohamed El-Erian, president of Queens’ College at Cambridge University, says a default would “probably tip the US into recession”.

That would have big knock-on effects for the rest of the world, many of which count the US as a key trading partner.

“The US is one of the biggest trading partners globally. It would be buying less products from the rest of the world,” he says.

Mortgages rates may rise

As well as hurting trade, Mr French says a US default would lead mortgages in other countries to become more expensive and could cause unemployment to rise.

“It would be pretty cataclysmic,” he says.

Why would problems in the US make mortgages more expensive other countries?

When a government wants to borrow money, it issues a bond or an IOU. In the US, it is called a Treasury bond. An investor charges the government interest if it buys Treasuries.

If the US government does not repay its debt or even pay the interest, “investors will look at this and say ‘well if the US can default, what’s stopping the UK defaulting?'” Mr French says.

Investors could then demand a higher interest rate to buy government debt.

“Interest rates on debt – be it your mortgage debt or public debt – they take their cue from how much risk is perceived and clearly [a US default] would be a massive risk event and therefore all debt would become more expensive overnight,” he says.

In fact borrowing in general – for governments, businesses and people – will likely become costlier.

Andrew Hunter, deputy chief US economist at Capital Economics, says: “US government debt is considered, in many ways, as a bedrock of the global financial system.

“It is seen as, usually, the single safest asset and essentially every other financial asset in the world is pretty much priced off of US government debt.”

The good news, he says, is that there is no particular individual country that would be vulnerable if the US defaults.

The bad news? “It is just it would be a potentially catastrophic situation for the global economy really.”

Prices could go up

The US dollar is the reserve currency of the world.

What that means is a long list of important commodities such as oil, which is used to make petrol, and wheat, which is ground into flour to make bread, are priced in dollars.

Should the US government default, the value of the dollar is expected to drop sharply.

That sounds like it could be good news for people outside of the US, but it would mean investors in commodities “don’t know how to price stuff”, Mr French says.

a woman in China counts dollar bills

“What you’d have with a US default is suddenly investors panicking and they’re wondering, ‘Is Japan next? Is the UK next? Germany next? What else is going to be defaulted on’,” he said.

“We suddenly have to reprice everything and in economic terms it is a risk premium. You get a risk premium added to prices and therefore bread becomes more expensive.”

If food and fuel become more expensive, it would raise the cost of living for millions of people.

Your pension could suffer

The US accounts for 60% of the value of global stock markets, according to Mr Mould.

“So the chances are people will have exposure to American shares in their pensions whether they know it or not,” he said.

And stock markets are likely to react badly to a US default.

But it is not all doom and gloom.

In 2011, Democrats and Republicans remained at an impasse over the debt ceiling until hours before a potential default.

US stock markets plunged. But the scare was short-lived and shares recovered from the sharp fall.

Mr Mould reckons that will be the case this time around.

Though people drawing pensions now could be affected, he says, “if you’re drawing it somewhere down the line then you’ve got time for it to make up that deficit.”

Source : BBC