US and Europe

United States of America – The worlds biggest defaulters?

Thursday October 17, 2013 Hugh Dixon

On the 17th October 2013 the United States of America Treasury estimates that it will no longer be able to sell bonds to raise money to pay for Federal Government expenses. This is the date that the US Treasury will have reached the debt limit imposed upon it by US politicians.  Federal Government expenses include interest payments on already issued bonds, social payments, Federal employees’ wages and salaries, and payments for a myriad of other Federal programs.

 

While the US Treasury does have US$30 billion in cash reserves, given the large amount of Federal Government expenses, this cash reserve will not last more than two weeks according to the US Treasury. This means that if the US debt limit is not raised before the cash reserve runs out the US Treasury will not be able to guarantee that it can pay its bills on time, as cash inflows from taxation are highly variable. Therefore the US government could end up defaulting on its interest payments to bond holders, or withhold social payments to its citizens, or both. Withholding social payments would in itself see American consumption take a large hit, which in turn would see job losses in the manufacturing and services sectors as the amount of money in the US economy being spent drops away.  This would push the current recovering US economy back into a recession, which the US could find much harder to get out of then the last one in 2008/09.

 

This threat of defaulting is a huge risk to the global economy, as the US government currently owes around US$17 trillion to other countries, banks and financial institutes.  If the US government defaults on even some of these debts the flow on effects could be huge. Banks and financial institutions owed money could collapse due to the losses. Further losses might be triggered as a flow on effect caused by large changes in the US exchange rate and interest rates that could occur after a default.

 

A default by the US government will see the cost of borrowing or the interest rates the US government, companies and citizens pay on their debts raise sharply to compensate lenders for the now much higher risk of losing their money.

This in turn will raise the cost of interest rates for the rest of the world, as the US government is seen as one of the safest places in the world to invest money, so if it pays more to borrow so will everyone else. 

In the future having to pay higher interest rates on its debt will cut the amount of money the US Federal Government can put into other spending, therefore reducing US economic activity in the future.

 

Also a default would cause the US exchange rate to fall as countries and banks who would normally buy US currency in order to purchase US Treasury bonds, could decide to sell up all of their US holdings and pull out of the US currency, because of the now riskier economy.  This in turn would lead to a run on the US currency, causing it to lose significant value.  We could see the $NZ dollar gaining parity with the $US, or even pass it.

 

The effects of a default on New Zealand would materialise in a number of ways. Mortgage interest rates could jump as the cost of borrowing rise as our banks borrow money internationally to fund mortgages for ordinary New Zealanders. Also we could see exports to the US fall, as US consumers will no longer be able to purchase the same amount of goods and services, this might also spill over to our exports to other countries as they cut back on expenditure, due to losses from the US default. 

 

Lastly we could see our exchange rate jump significantly as the US currency falls.  This exchange rate movement would see our exports become even less internationally competitive. Combined these effects will have a negative impact on the New Zealand economy.