What would happen if the US defaults on its debt?

Question

As has been widely discussed already, the situation in Greece is considered more serious than in the US, as they have dollar-denominated debt and can only print Greek currency. The US, has the benefit of World Reserve Currency status. All of that does make sense, but I'm thinking there might be more to the story. So I would like to invite speculation on the consequences if the US one day defaulted on its debt.

A country going bankrupt is hardly a novel event, but few countries of the wealth and influence of the US are can be found in historical precedent. One of the only examples that came to mind is when Russia defaulted in 1998. That had global repercussions to North and South America and beyond. Also it destroyed the business model of Long Term Capital Management, an investment fund headed by a team of nobel-prize winning economists and mathematicians.

World Reserve Currency aside, is the Russian default a fair comparison? What different things might we expect if it were the US to default in the coming years?

Answer 1

The Russian default was an extraordinarily insignificant event compared with a current-day US default on all treasury securities. There are no remotely similar events to compare it to. This makes it hard to make guesses about all the ramifications. Still, speculating is fun.

My guesses, based on a complete default (no money recovered) on all treasury securities:

• Massive failure of important financial institutions all across the world. LTCM was a hedge fund: a type of institution the is specifically expected to have significant failure risk. On the other hand, treasury securities are held by institutions that are not well-equipped to bear risk. Pension funds, banks, central banks, possibly whole governments would immediately fail. There would be ripple effects as other institutions linked to them (or who they owe money to) faced an uncertain future.

• Total freezing of most important financial transactions and many markets. Treasury securities are used as currency and margin in many large and important financial transactions. We witnessed a great deal of hobbling of financial institutions and markets when a few CDS's and mortgage-backed securities failed. The loss of confidence in financial institutions and markets would be incomparably greater.

• Drastic increases in all interest rates and a sharp decline in all stock prices. The Russian default had consequences because it caused investors to dump risky investments in favor of safe ones. A failure of the safest investment (treasuries) would cause utter loss of confidence in all investments and investors wouldn't know where to put money. Cash maybe? They would pull money out of both safe and risky investments, driving down both stock and bond prices.

• Widespread unemployment. Cash available for lending would dry up. Firms would be unable to borrow and have to forgo projects and lay people off. These people would reduce their spending and default on some loans, causing amplified effects on interest rates and economic activity. I would not be surprised if starvation and loss of social order ensued.

• Irreparable harm to confidence in the US government. The government would never again be able to borrow at low rates, it may not be able to borrow to fund its usual deficit. This would be problematic since the depression and economic turmoil would require expanding the deficit. It would be my guess that the US government as we know it would not continue.

I know this sounds a little alarmist, but wholesale default on all US government debt is truly an end-of-the-world-as-we-know-it scale event. The world truly would change dramatically. Probably future generations would read about the golden age of humanity that ended with the great default.

Realistically, the US is not going to completely default on its debt any time soon. If there was even a bit of worry about it, people and institutions would stop using it as such a critical component of their transactions and saving. This would also be a dramatic change, but it would happen over time and reduce the effects, should a default ever happen. I'm not sure what people would use as a substitute. It would be uncharted territory.

A more likely, but still apocalyptic, scenario would be some partial default or sustained high inflation. See the above consequences, but scaled down and including loss of confidence in the dollar.

Answer 2

I would put it that the US have already defaulted on their debt. They just keep kicking the stone down the road just like PIIGS did in the last decade before the "crisis".

The deficits have not gone down which is indicative that there is no real will to adjust the deficit spending. It is therefore easier to treat them as de facto defaulted instead of default in theory. Once you have jumped over that cliff, you can start adjusting positions accordingly instead of diving in illusions.

The dollar is no longer a reserve currency, it is a reserve currency among others. All the large central banks are in the same predicament issuing new debt and money. The business and speculative banks keeps lending irresponsibly and the central banks keeps bailing them out.

Look at how the central banks balance sheets have expanded in the last decade. Amazing.

ECB balance sheet

FED balance sheet

You asked: What would be the consequences? Look at how Argentina was handled. Part of the debt was written down, while a vulture fund wanted to be paid in full with the support of a US court. So a US court would also have to apply that common law practice on the US government and request it to pay in full. As the US government could not pay in full (otherwise it would have done it in the first place) it would have to ask the Federal Reserve to print even more money (just like they have been doing in the last decade).

Therefore I conclude they have already defaulted, they are just pretending they have not.

Put it in other words. I work today on the promise you will work tomorrow to balance things out. I build your house, you say you will mow my lawn. But instead you print money and watch videos of cats instead. I have to mow my own lawn and work in a coffee shop while you print money. You say there is not enough money to go around, but speculate on the Housing Futures market in Las Vegas, Chicago and London. The moral dilemma game can only be played until those who are being fooled gets wiser.