Can the Rest of the World Ignore Congress?
A point of breathless speculation by the international twitterati has been whether or not the US Congress will force the US to default on its credit obligations by refusing to raise its debt limit. Other people have dealt with what the debt limit means (if Simon Johnson is too liberal for you, there’s Bruce Bartlett), and what a congressional abrogation of responsibility would mean. The prospect that we’ll find out the practical consequences of a US “default” is a frightening one, but it’s also an interesting one from a strictly theoretical point of view.
This is basically monetary climate change. A vast vast majority of experts believe it would be catastrophic, and everyone else in the field concedes that a default would be bad but that Treasury wouldn’t allow it to happen. (See: Heritage and Cato for examples of the latter) Basically anyone who knows a damned thing about economics admits that the US no longer being able to service its debt and honor its obligations would be a bad thing™. The only difference is that some policy think tanks are telling Republican lawmakers that it’s not their fault if it happens… which has somehow translated into “no big deal” to them. So there’s a big expert consensus, a minority of dissent that is then distorted into meaning something completely different by the House Flat Earth Caucus.
Regardless, the theoretical question here is how the Rest of the World would react if the Treasury were suddenly unable to service its debt obligations.
Unfortunately history isn’t a particularly useful gauge when we consider what’ll happen in the aftermath. The closest example we have in recent memory is the Nixon Shock, but that wasn’t a question of US debt servicing but of gold convertibility. Decoupling the US from the gold standard set in Bretton Woods did noticeably impact foreign currencies (which had traded on the US’s managed standard system to hoard gold reserves), and eventually led to the inflation that created the 1970s stagflation. On the other hand, the dollar still remained a de facto international reserve currency.
The possibility exists (however unlikely) that this time the dollar could face a run similar to what other defaulting countries experienced in the late 20th century. The Asian Financial Crisis is perhaps the largest case of default in recent memory. Let’s remember that the national economies of places like South Korea took a massive hit in the order of ~30% in the wake of the currency crisis. These cases showed what happens when foreign confidence in a currency falls and investors pull out in droves. The resultant capital flight can cripple an economy by starving it of available capital and devaluing the country’s purchasing power.
The thing of course is that the US’s place in the global economy is still at a scale unrivaled by any other defaulter to date. Of the $12 trillion in global foreign currency reserves, COFER knows the currency composition of approximately $6 trillion. The dollar is by far the largest composition of these reserves, making up $3.7 trillion with the Euro trailing a distant second at $1.4 trillion. Other currencies including the Sterling and Yen are nearly rounding errors in the $200 billion range.
That is to say the vast majority of foreign currency reserves are likely in dollar denominated assets. When you then include things like treasury obligations the share rises further. This then raises the question: Would a debt ceiling failure press the world into abandoning the dollar?
The answer I think to that answer is a solid no. China doesn’t want to assume the role of world creditor. It is in fact panicking at the moment at the prospect of a US credit devaluation, (and perhaps counterproductively) demanding that US lawmakers put their house in order. The potential impact to the Chinese economy both in lost export competitiveness and in its own foreign reserve devaluation would be enormous.
The Eurozone really can’t afford to act as a substitute reserve. Or rather no one trusts them enough to act that way. US Congress might be dysfunctional, but people don’t doubt (or at least most don’t) that the US will still be here in 10 years paying back its debt obligations in dollars. There’s a very real possibility the Eurozone might not even be here in 5 years.
Finally the other potential reserves, the sterling, yen, franc, Canadian dollar, and SDRs aren’t independent enough to function as such. The first four would essentially collapse their national economies if they suddenly faced massive deflation. Special Drawing Rights at the IMF might fare slightly better, but it would devalue right along with the dollar.
So more than likely the rest of the world will swallow a technical default by the US government, selling their short-term bonds and older bonds at a reduced price, but not really factor in the possibility of a long-term default. We already see some signs of this in the bond markets, where US treasury bond volatility is still rather low. Most investors still see the US Dollar as the safest investment. Which perhaps gives us a better idea of the state of the world than anything else.
So yes, at least in the short term the world CAN ignore the signs of crazy coming from Congress and pretend that things will be paid and settled in the long run. The question is how long they’ll keep up that pretense if this becomes a common play in US politics.
Breaking – Mon Calamari News Network’s senior White House correspondence had this to say about John Boehner’s offer of a short-term debt limit increase: