Loading...
See More

Downgrade vs default

Jul 29 2011 10:35 Reuters

Related Articles

Lagarde warns on US default or downgrade

Obama warns public on US debt fallout

Timeline of a crisis

IMF urges swift action on US debt

World hopes US will avoid debt 'suicide'

Obama seeks 'Plan B' as debt talks stall

 
Washington - How much damage the US debt ceiling scuffle does to the United States' reputation in global financial markets boils down to two increasingly plausible but very distinct outcomes: downgrade or default.

The former, while painful, might allow financial markets to hobble through without major incident, though it would leave the country under a cloud of financial uncertainty that would threaten an already fragile economic recovery.

A mere ratings cut would reflect the judgement of private agencies and could be glossed over by investors given a lack of viable alternatives to the giant $9 trillion-plus market for US government debt.

That's the benign scenario.

An outright debt default would be much more unpredictable - and potentially cataclysmic.

Such a historic event as failure to make payment on Treasury bonds, considered the ultimate safe haven in banking, would cascade through financial markets and the world economy, dealing a long-term blow to the global standing of the United States.

"Default on the debt would just be a catastrophe, it would be Lehman times 10," said Joseph Gagnon, a former Federal Reserve economist now with the Peterson Institute for International Economics. "Financial markets would seize up. No one would know what is safe any more."

The US Treasury has warned it will run out of cash to pay the nation's bills on August 2 unless deadlocked lawmakers raise the nation's $14.3 trillion debt ceiling by then.

Another possibility is that the government skirts a debt default by withholding payments to government workers and benefit recipients, buying more time for Congress to raise the statutory borrowing limit.

This scenario, which would still likely lead to a ratings cut, runs a high risk of tipping the economy into recession, but would nevertheless be less calamitous for the global financial system than an outright debt default.

"They are playing with fire and they could well be burnt. No compromise would put us in unknown and dangerous territory, at a very delicate moment for the world economy," said Carlos Vegh, economics professor at the University of Maryland.

With a default, confidence in the United States as an investment destination would be eroded, potentially for many years to come. Countries like China and Japan, the largest foreign holders of US Treasuries, would over time further diversify their portfolios away from dollar assets.

America as emerging country?

Default would catapult the United States to the top of the list of sovereign states whose political dysfunction supersedes sound economic management - above countries like Argentina, Ecuador and Russia.

The country's image as a political basket case is already being cemented.

"US lawmakers are providing a sad spectacle," said Vegh at the University of Maryland.

"When you add this ridiculous stalemate over raising the debt ceiling to the less-than-stellar response to the financial crisis, it confirms the impression that the US is regressing and becoming more like an emerging country."

The risks to the US economy are high enough even without the spectre of a debt default, according to a poll published by Reuters on Tuesday.

A majority of the economists surveyed believe the United States will not emerge from the current political stalemate over the debt without a ratings downgrade. More than two out of three said the economy was already being hurt by the scuffle.

Even a downgrade alone would probably push up borrowing costs for US financial firms, putting a crimp on lending.

A failure to make timely debt payments might also trigger credit default swaps contracts, setting off a chain reaction of losses that sends shivers through the world's big banks.

Industrial activity would be hampered, setting in motion another economic slump that could be as severe as the one faced in late 2008, in the wake of the failure of Lehman Brothers and bailouts of insurer AIG and large Wall Street firms.

"To say that the effect from a sharp contraction in obligations to the broader economy would be quite severe might be an understatement," said Michael Cloherty, head of US rates strategy at RBC, in a research note.

"Another severe downturn would be just about a done deal."

us  |  us debt default
NEXT ON FIN24X

 
 
 

Read Fin24’s Comments Policy

24.com publishes all comments posted on articles provided that they adhere to our Comments Policy. Should you wish to report a comment for editorial review, please do so by clicking the 'Report Comment' button to the right of each comment.

Comment on this story
5 comments
Add your comment
Comment 0 characters remaining
 

Company Snapshot

We're talking about:

Small Business

Retailers of any shape and size can now unlock the power of mobile transacting.
 
 

Hottie of the day: Nicole Meyer!

Nicole is the cover girl for the 2014 edition of SA Swimsuit! Check out some smoking hot pics of here here.

 
 

Men24.com

11 things men don’t know about their clothes
Hilarious mortal kombat elevator prank!
This is how the Top Gear presenters spend their £55 million!
Thirty and still single? There’s hope!

Money Clinic

Money Clinic
Do you have a question about your finances? We'll get an expert opinion.
Click here...
Loading...