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What Would Happen if the U.S. Defaults on Its Debts

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If the United States defaults on its debt, the results for the global economy would be catastrophic. Here are five things to know about the U.S. debt ceiling crisis now playing out in Washington.

What is the debt ceiling crisis?

U.S. officials warn that if the government is unable to raise the amount of money it can borrow, the country will be unable to pay all its bills. If that happens, the results would not only be catastrophic for the U.S. economy but for the global economy.

The U.S. Treasury says that by October 17 the government will exhaust its ability to stay beneath the current $16.7 trillion federal debt ceiling, which is fixed by law, and would have only about $30 billion left in cash. That's not enough to keep up payments of salaries and social benefits at home, plus interest due on trillions of dollars borrowed internationally.

That would be an unprecedented situation. The United States hasn't defaulted on its debts since 1790, when it was a newly formed country. Today it is the world's strongest economy, with trade and investment ties to virtually every other country, and no state of that economic status has ever defaulted on its debts before.

But whether the United States' two political parties -- President Barack Obama's Democrats and the opposition Republicans -- can agree on letting Washington borrow more money to pay its bills is an open question.

The Republicans say they are ready to raise the debt ceiling after they negotiate with the Democrats over how to reduce the amounts the government spends for social programs. But the Democrats say they will negotiate only after the ceiling is raised because negotiating beforehand would put them under intolerable pressure.

That leaves the two sides in a showdown where neither wants to concede to the other. At the same time, both say they won't let the government default.

What would be the impact on the global economy if Washington defaulted?

Among the first to feel the impact would be foreign countries, institutions, and market funds that have bought U.S. Treasury bills as a safe way to keep money and earn interest.

"If there were an outright default on Treasury [bill] obligations, there is no doubt that would create huge chaos in financial markets," says Ethan Ilzetzki, a professor of economics at the London School of Economics. "For one thing, these assets are used as reserves by many private banks, by many central banks, and if their value suddenly plummeted it is hard to fathom the exact implications of that."

Here are just some of the implications:

International rating agencies would automatically downgrade the creditworthiness of banks holding U.S. Treasury debt, making it harder, in turn, for those banks to borrow the money they need to keep operating.

Banks with reduced assets would dramatically decrease the amount of money they lend, leading to a freeze in credit available to businesses worldwide.

The value of the suddenly-less-desirable dollar would plummet, throwing into disarray the prices of dollar-pegged global commodities like gold and oil.

And the economies of the United States and those countries closely tied to it would slow down and possibly slide into recession.

The two countries that hold the most U.S. debt, Japan and China, have signaled real alarm over the possibility of a debt default. Officials in both Tokyo and Beijing have warned of market turmoil and chaos if Washington cannot find a quick resolution to the crisis.

What's driving the debt-ceiling crisis?

In recent years the world has become used to seeing government debt crises wrack Western countries. But whereas the crises in Greece, Spain, Portugal, and elsewhere have been driven by economic factors, the crisis in the United States is purely a political quarrel.

"This is sort of a homemade crisis," notes Johannes Thimm, an expert on trans-Atlantic relations at the German Institute for International and Security Affairs in Berlin. "You can argue about whether the debt of the United States has become too big as a ratio of their gross domestic project or their budget or any of these measures, but right now it is because of the gridlock in Washington that this crisis erupts and not because the markets distrust the Americans' ability to service their debt."

Instead, what drives the crisis are deep ideological differences over appropriate levels of government spending. That mirrors debates in other countries now recovering after years of economic slowdown precipitated in part by heavy government borrowing to fund social and other programs.

"You have the Democrats and some of the more establishment people in the Republican Party basically saying that we have had a period of austerity, therefore the idea we should cut back even more would be bad for the economy, we need to keep government spending going and we should increase the debt ceiling," says Matthew Elliot, founder of the London-based U.K. Taxpayers Alliance.

"Whereas you have people on the free-market side of the Republican Party, the side which has been influenced by the Tea Party movement, and they are saying that we haven't really had any serious austerity, we still have huge deficits every year, the national debt is going up and therefore we need to cut back in a big way."

Can a political solution be found?

Many observers expect the showdown to end as the last U.S. debt-ceiling crisis did in 2011. Then, the two political parties reached an 11th-hour agreement to make spending cuts and raise the debt limit, thus averting a default.

But passions around this crisis are higher on both sides than three years ago. The debt-ceiling crisis comes as a deadlock between the two political parties has already forced a partial government shutdown since October 1 because they cannot agree on the government's proposed budget for the new fiscal year.

Still, the homemade rather than external nature of the crisis makes it one the United States can solve through compromises by both parties. However, it also means it will likely be averted only at the very last moment and amid very tough negotiations.

Could the U.S. economy be damaged even if the crisis is averted?

It is a real possibility. The international credit-rating agency Standard & Poor's cut the U.S. ranking from top level AAA status to next best AA+ status in August 2011 following Washington's last battle over the debt ceiling. That meant that the international investment community lost some of its confidence in the belief that the United States will always be a country that pays its bills on time and in full -- regardless of its political conflicts.

Ilzetzki says that continued political wrangling of the kind going on in Washington now cannot help but contribute to a further weakening of investor trust over time. And that includes trust in the U.S. dollar as the international reserve currency.

"The day will come, whether it is 10 years from now, or 20 years from now, or 50 years from now, that the dollar may very well lose its status to some other currency, be it the euro or the Chinese yuan or some other currency," Ilzetzki says. "I have no doubt that when history is written decades from now, the political battles that we are seeing now in Washington will probably be faulted for that."

Copyright (c) 2011. RFE/RL, Inc. Reprinted with the permission of Radio Free Europe/Radio Liberty, 1201 Connecticut Ave., N.W. Washington DC 20036. www.rferl.org

(c) 2011 Federal Information & News Dispatch, Inc.

Original headline: Explainer: What To Know About The Looming U.S. Debt-Ceiling Crisis


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