Debt 'Chicken' From the U.S. Threatens the Global Economy
The only commodity in short supply during the Global Financial Crisis was confidence. The trigger for the crisis was loss of confidence in securitised sub-prime loans (mortgages) which had been bundled together and sold on to investors as investment-grade products. Sub-prime loans were offered to people with poor credit ratings and patchy credit histories, but because of the higher perceived risk with such borrowers, they were charged higher interest rates than would be the case for "normal" borrowers. The idea was that by bundling the loans together, the inevitable defaults which occurred would be absorbed by the much higher level of debtors who honoured the terms of their loans. In the end, so-called "toxic assets" nearly caused the world's financial system to collapse. It has taken six years for the global economy to recover from the crisis, but that recovery has proved weak and fitful. It would not take a major loss of confidence for it to be reversed, plunging the world into a fresh cycle of recession.
The world is watching the US politicians as they play with fire over the refusal to pass a budget. To many abroad, it is an anathema that the Republican controlled House of Representatives would prefer to see 700000 public employees sent home; museums and national parks closed and knock-on effects which harm business for the sake of thwarting the Affordable Care Act. It is estimated that the shutdown is costing the US economy about $300 000 000 per day. However, of a more pressing concern to global interests is the US debt ceiling deadline of 17th October. Unless bipartisan agreement can be achieved to raise the debt ceiling above its current level of $16.7 trillion by a further trillion dollars, the United States of America is risking a default on some of its obligations.
China holds approximately 8% of US Treasury bonds. A senior official, vice finance minister Zhu Guangyao, has pointed out that China is "naturally concerned about developments in the US fiscal cliff", noting that the clock is ticking. In Europe, the belief is that US lawmakers will avoid this costly own goal. Speaking yesterday, European Central Bank Chairman, Mario Draghi, said that he didn't believe the US would default on its debts. International Monetary Fund director Christine Lagarde declared that finding a solution to raising the US debt ceiling was "mission critical"
The US Treasury has cautioned that failure to get a fresh debt ceiling agreed in time could trigger a crisis worse than the Global Financial Crisis itself: "A default would be unprecedented and has the potential to be catastrophic. Credit markets could freeze, the value of the dollar could plummet, US interest rates could skyrocket, the negative spillovers could reverberate around the world, and there might be a financial crisis and recession that could echo the events of 2008 or worse."
Indeed, since the government shutdown struck, the dollar has lost ground against other major currencies, but were the world's largest economy to be unable to honour its financial commitments, its very role as the world's reserve currency would surely be called into question.
If the unthinkable were to happen, the US would face the same dilemma experienced by Greece, Ireland, Portugal and to a lesser extent Spain and Italy. The cost of borrowing on open financial markets would rise sharply for the very reason that lenders could be no longer certain that they'd get their money back. Unlike the Southern European economies, it is unlikely that the US could rely on an EU/IMF-style bailout to ensure that its borrowing costs were manageable and then the world's financial system would be into dangerous and uncharted waters. US lawmakers have it within their power to step back from the abyss, the question is will they do so in time?