US Default

There has been a lot in the news recently about the possibility of a US default – what does this mean? A default is a term used for when a country refuses to pay its debt. Generally this is because they can no longer afford to, however there could be other reasons, e.g. a change of government brings in a socialist regime whose policy was to default. A default may not be of the entire debt, debtors may be required to take a ‘haircut’ – which is considered a default – meaning they wont be paid back the entire amount they are owed. For example, the Greek government defaulted on its debts in October 2011, but told investors to take a 53.3% haircut. They wouldn’t loose the entire amount they had lent, but would still lose half.

The reason the US is close to default is because there is a government debt ceiling instilled in the constitution. If this can not be raised to allow the government to take on more debt, then the US won’t be able to pay its debtors any more. Although this doesn’t necessarily mean a complete default (i.e. refusing to pay off all its debt completely) it would be catastrophic for many reasons.

Firstly, there is a lot of US debt in issue – ($17 trillion), a default would result in a loss of money for investors. These investors could be people investing their savings and pensions, insurance companies, pension funds, banks and foreign debtors (banks, government, sovereign wealth funds). If these individuals and companies lost money they wouldn’t be able to spend it elsewhere. This means that there would be a fall in consumption (a component of aggregate demand) meaning GDP falls. A reduction in profits for firms (as a result of a default) is more likely to mean that the firm reduces future investment as oppose to money it returns to shareholders. A fall in investment is also a component of GDP and so would cause it to fall; it would also affect the long term productivity of a country and have widespread implications.

Many people rely on such investment companies to invest their pensions or savings with. If they collapsed as a result of the US default then some people would loose a lot of money (the investors of such companies could include – individual people investing savings and or pensions). This would affect ordinary people who may loose their pensions and life savings. They would reduce their spending and try to save to make up for it, this would have a knock-on effect – called a negative multiplier – for the agents they buy from. To explain this better let us imagine an old lady who has lost her pension as a result of the default of the US government and an eventual collapse of her pension firm. Her income has been severely reduced so she has to reduce her consumption to match this, she may also decide to increase her savings (she’d have a higher marginal propensity to save) for a rainy day. The result of this would be that she may decide not to buy the latest sewing machine, therefore the sewing machine company sees a fall in its revenue, they may therefore fire a worker who now has less money to spend, etc. This domino effect is the negative multiplier and can cause a greater fall in GDP than the initial withdrawal.

Sovereign nations which have large deposits of US debts (e.g. China) would find that their balance sheet has been greatly reduced after a US default. This would cause many problems, each worthy of their own essay, but it is safe to say that it would be catastrophic!

Secondly, by defaulting the US government would no longer be credit worthy, hence very few investors would trust the US government to ever pay back a bond again. The resulting interest rate that the government would have to pay on any future bonds (assuming it CAN actually borrow) would be so high that it would be too expensive to borrow. If a government can’t raise funds through issuing debt (bonds) then it will have spend less than it earns in taxation and other revenue.

If the US government did a complete default on all of their debt tomorrow then they would have fewer costs (they would spend less) as a result of a fall in spending on debt refinancing – i.e. paying interest on all the bonds it has in issue. But simultaneously it would have to ensure that spending didn’t exceed taxation as it wouldn’t be able borrow to cover the difference. This fall in spending would also have a negative multiplier. Furthermore it may mean a cut in welfare spending thus reducing people’s income. The government may also be forced to reduce taxation to cover its spending commitments, this would mean there is less disposable income for consumers to spend leading to a further fall in aggregate demand. They would also have less money to save which would cause an increase in interest rates thus deterring spending.

The cyclical effects of the ensuing recession would exacerbate the situation as benefit claims would increase and tax receipts would falls as the economy experienced a huge contraction which would inevitably result from a US default.

Thirdly, the fall in consumer spending would not only affect domestically produced goods but is also likely to result in fewer imports. This would cause a shock to other economies who would see a fall in their exports and hence a contraction in GDP (which could have further consequences) the ultimate effect is likely to be a worldwide slump which would be further compounded by beggar-thy-neighbour policies. Other countries would also have their debt burden analysed by investors, and who would potentially face higher interest rates putting an increased burden on the existing debt and making it harder to roll-over debt. This could mean that foreign governments also have to try and tighten public purses reducing world demand further.

However the fall in the dollar which would occur after a default would cause exports to be much cheaper for foreigners, this may mean that they buy more which could boost US GDP and help to pay revenue for the government to spend. It would also provide jobs and income for workers that were laid off as a result of the default.

It wouldn’t all be doom and gloom, the price of gold would rocket as people turn away from dollars and other curriencies towards gold. Some countries’ currencies would also rocket as they become safehavens but this may not be ideal for those countries because it means their exports become more expensive for foreigners and are thus likely to fall.
A lot of assumptions have been made in this analysis, but it just goes to show how unpredictable and devastating a default could be.

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