The Impact of the U.S. Defaulting

Christine Lagarde believes the impact could be large and global.

The impact could be large and global, as Christine Lagarde points out in this article.

“Frankly, to have a default, to have a serious downgrading of the United States’ signature would be a very, very serious event,” said Ms. Lagarde at a meeting of the Council on Foreign Relations in New York. “Not for the United States alone, but for the global economy at large because the consequences would be far-reaching. It would not stop at the frontiers of the United States; it would go beyond.”


If the US were to default on the interest on its bonds, private economists say, it would cause banks around the world to write down the value of their enormous holdings of US Treasury securities. At the same time, stock markets around the world would probably plunge.

“That would have a devastating effect,” says Jay Bryson, international economist at Wells Fargo Economics Group in Charlotte, N.C.

If banks were to write down the value of their bonds, they would have to raise capital quickly or shutter their doors, Mr. Bryson says. “Their capital base would shrink, and when that happens, they are less likely to make loans,” he says. “It would spill over very quickly to the real economy.”

In the past I’ve argued that one of the reasons why we have anemic economic growth has been regime uncertainty. The idea is that during a crisis politicians see opportunities to push through policies and legislation they’d not be able to get through during non-crisis periods. This in turn exacerbates the uncertainty many see in the economy, not reducing it. This in turn can lead to less investment than there otherwise would be and that in turn could lower economic growth.

The above description of a U.S. default is something that would increase uncertainty and reduce investments in a way that we have not seen since probably the Great Depression. And it is indeed tied to our current economic/financial crisis. The Tea Party wing of the Republican party is enjoying increased power due precisely to the crisis and the higher debt levels such crises always bring about.

Of course the U.S. could simply decide to fall on its own sword,

Nariman Behravesh, chief economist for IHS Global Insight in Lexington, Mass., says the Federal Reserve would step in to stabilize the financial markets.

“I suspect the Fed already has contingency plans for this problem,” Mr. Behravesh says. “It does not necessarily have to be a disaster.”

The US Treasury would continue to pay the interest on US debt, he says. However, he estimates that the government is spending 40 percent more than it’s taking in. This means the government would have to stop paying other bills coming due.

“We would have to slash paying for Medicare, issuing Social Security checks. That would kill the economy,” Behravesh predicts.

I don’t think many who advocate such massive and draconian cuts to Medicare and Social Security appreciate is the impact on the U.S. economy. In May of this year the federal government spent $233 billion, 40% of that is around $93 billion. That would have a pretty significant impact on the U.S. economy. I’m all for getting our fiscal house in order, but that is absolutely not the way to do it.

“To be precise, our studies show that a reduction of one percentage point on the deficit entails in many instances 0.5 percent off the growth number,” she enumerated. That’s why, she said, the IMF recommends any budget cutting take place at a time when the economy is growing.

Bahravesh, for one, says Congress should postpone major spending reductions for at three to four years. “It’s a bit of a balancing act. We think you want to backload it versus starting it next year,” he says.

Part of me agrees with this. Cuts right now are probably not a good idea. At the same time neither are tax increases. But at the same time whatever budget/debt ceiling agreement is reached must be seen as credible. That has often been the problem with many of these budget proposals. “My budget proposal will cut the deficit by x% in 10 years!” Problem is it rarely happens. Yeah, yeah, I know Bill Clinton…like I said rarely happens.

If the rating agencies downgrade US bonds, it might have a negative impact on some money-market mutual funds and insurance companies whose standards require them to invest in the highest-rated bonds. But it might not be disastrous, Bahravesh says.

“What are the alternatives?” he asks. “Where do money-market funds and insurance companies go? Do they buy Chinese bonds or German bonds? There are no good alternatives.”

Basing policy on hoping for the best strikes me as not very good policy.

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Steve Verdon
About Steve Verdon
Steve has a B.A. in Economics from the University of California, Los Angeles and attended graduate school at The George Washington University, leaving school shortly before staring work on his dissertation when his first child was born. He works in the energy industry and prior to that worked at the Bureau of Labor Statistics in the Division of Price Index and Number Research. He joined the staff at OTB in November 2004.


  1. Ron Beasley says:

    Part of me agrees with this. Cuts right now are probably not a good idea. At the same time neither are tax increases.

    The Bush tax cuts didn’t help the economy and probably contributed to the bubble and burst. I really doubt that it would hurt the economy if they simply went away. The way to avoid a downgrade is a bipartisan announcement that the Bush Tax Cuts will not be renewed. That would also eliminate the uncertainty.

  2. Ebenezer Arvigenius says:

    Democracy is fine, it really is. At least when citizens truly love their country and want to do what is best for it.

    Unfortunately it would. One of the things both sides tend to ignore is that the status quo of the US is massive defecit spending. There is simply a lot more money in the market than there is actual wealth generation.

    You can reduce spending by either shrinking expenditures or by increasing taxes. In both cases, excess money is removed from the system (in one case by not introducing it, in the other case by using the additional revenue (real wealth) to reduce borrowing and thus reducing the total circulation). Both ways will hurt the economy.

    I personally would opt for more taxes. Since wealth is increasingly concentrated at the top, we have a strong surplus of investment capital (which helps bubbles) and a lack of consumption. Tax increases therefore damage the more robust sector of the economy. But the hurt will happen regardless.

    Ideally, this would happen in better years. This timing problem is, basically, understood by every serious economist. Politically however this has always been a non-starter. Thus the current situation.

  3. Barry says:

    Steve V erdon: “In the past I’ve argued that one of the reasons why we have anemic economic growth has been regime uncertainty. The idea is that during a crisis politicians see opportunities to push through policies and legislation they’d not be able to get through during non-crisis periods. ”

    First, Krugman has shot this out of the water – get informed. Big businesses are sitting on tons of cash and making money hand over fist.

    Also, the ‘uncertainty’ theme is something that, like the Tea Party, emerged in January 2009.

  4. Ebenezer Arvigenius says:

    The quote above should have been

    I really doubt that it would hurt the economy if they simply went away.

    of course. Dang copy and paste :).

  5. Bob says:

    The sad fact is that you must cut $3.1T just to keep the budget from growing year over year. The cuts that are discussed are cuts to a baseline budget that grows 7% year over year. That means that in 10 years the budget doubles. So a $1T cut means next years budget will be $179B more than the current budget.

    I doubt one in a hundred people are aware of the shell game going on in DC. That is why Dems always claim cuts to programs when the absolute value of funding goes up. Who assumes a 7% growth in their personal budgets?

  6. Rob in CT says:


    The population of the USA grows. A household preparing for the birth of a child would probably assume a growth in their household budget.

    There is also inflation (low right now, but it’s there).

    I don’t know where the 7% number you mention comes from. Is it an average growth rate for the budget over a certain timeframe? If so, what’s the timeframe. Is it inflation-adjusted? Is it pop-growth-adjusted?

  7. george says:

    Its actually a pretty good way to make sure that the US dollar ceases to become the international currency, and to ensure that China’s economic influence continues to grow. An American default will solidify what much of the world has already been talking about for the last decade – the US can’t be trusted financially.

  8. Bob says:

    @Rob in CT:

    What difference does it make if it is population adjusted. 7% growth as a starting point in a good economy is rediculas never mind in the stagnation Obama has created.

    All the cuts are based on a budget with a $1.6T addition to the debt. The GDP has dropped, and we currently have a debt to GDP ratio greater than 100%. The best evidence is a ratio better than 90% effects growth, jobs and the standard of living.

    Even with the Ryan plan it takes five years to balance the budget at another $5T in debt. Nothing being discussed even stops the growth of the budget much less stop accumulating