Most governments go to great lengths to avoid default, even on their external debt (the debt owed to foreign creditors). Understanding why is a bit of an intellectual puzzle. Early theories of sovereign debt assumed, more or less, that sovereignty created difficulties credibly contracting for repayment, and that default would thus be viewed by most governments as an attractive alternative to painful fiscal choices.
However, theories don’t always play out as expected. Even though it is difficult to force a sovereign country to repay its debts by going to court, governments value their ability to access international markets. For many emerging market governments, the ability to pay their debt on time is an important signal of credibility to domestic voters as well as foreign investors. Thus, emerging markets typically opt to pay their debts even when they rationally should seek to restructure it with their creditors. Sri Lanka is the latest case in point: Sri Lanka continued to make payments on loans to China and on its international bonds until it literally ran out of usable foreign exchange reserves. Russia was so keen to keep paying its foreign debt that Western countries had to extend sanctions in response to Russia’s invasion of Ukraine to force it into an actual default.
For those countries around the world that scramble to find the resources to repay their debts and worry about squandering hard-earned access to bond markets, it must be inconceivable that a country that has achieved the United States’ enviable position—where it can borrow in its own currency, at low rates, from investors around the world—would voluntarily choose not to pay.
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Countries that can borrow in their own currencies don’t default unless they are forced to do so. Period. A U.S. default would reverberate around the world, and not simply because of the outsized role that the dollar and U.S. Treasury bonds play in global markets. A default would signal to the entire world that the United States is a tired great power, so consumed by domestic divisions that its capacity to sustain its global presence is in real question.
A default of choice would diminish the dollar’s appeal as a global currency for payments and finance. Probably not fatally, at least not in the short run, as there is an assumption in the market and around the world that the United States could fix any default quickly. There also isn’t another currency that can replace the dollar in the short run—in large part because there isn’t another market as big and as deep and as liquid as the U.S. Treasury market. $12 trillion in reserves globally need a home. Their size towers over the market for German bunds, French OATs, or Chinese central government bonds. The $7 trillion held in dollars can really only be held in Treasuries or at an account with the Federal Reserve Bank. Scale matters.
The United States cannot make the yuan into a global currency, even by default. The yuan’s ability to function as a safe reserve asset and a vehicle currency for global trade ultimately depends on the choices China makes. But the United States can make Treasuries into a risky asset. As Paul Krugman astutely noted, a U.S. default doesn’t magically conjure up other safe reserve assets—rather, it creates a dearth of truly safe assets globally.
Ultimately, though, the willingness of the United States to honor its obligations shouldn’t depend on whether Congress judges default to be a gift to China or not. The dollar’s most important role by far is domestic.
The national market for Treasuries helps to knit the fifty states together financially. The Treasury market actually predates the creation of the Federal Reserve System in 1913. Banks around the country in the late 1800s might not have trusted each other, but they trusted the U.S. Treasury and the United States’ commitment to honor its debts. The musical Hamilton and the 14th amendment ultimately tell the same story: the full faith and credit of the United States is an essential component of the union.
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The Treasury market is the reason why money market funds are safe: they hold short-term Treasuries, or lend against Treasury as collateral. It is the reason why banks can honor their deposits: they hold Treasuries to meet their liquidity requirements. It is the reason why big brokers can provide margin loans to Americans who want to buy into Wall Street: ask a broker-dealer how they would raise cash if they could not borrow against safe Treasury collateral. And, of course, they also back the dollars that circulate inside the United States (Federal Reserve notes, technically). Investors around the world hold $7 trillion of marketable Treasuries. Investors in the United States hold over $16 trillion.
The Treasury’s debt—whether it be short-term bills, medium-term coupon-paying notes, or long-dated bonds—is so fundamental to the U.S. financial system that it is hard to convince investors to take the threat of default seriously. The consequences are so severe that market institutions almost certainly would give the U.S. time to correct so obvious a financial mistake. Financial institutions ultimately need the Treasury to be a safe asset too—the market needs a dollar benchmark, and no bank (not even J.P. Morgan) can provide an alternative benchmark on its own.
From a purely technical point of view, many of the options available to the United States in the event that the debt ceiling starts to bind are ultimately good for bonds. Prioritization of Treasuries over other spending? Awful for the economy (and U.S. companies) but good for bonds. Tight limits on spending that crimp the United States’ ability to respond to crises, both foreign and domestic? Bad for the United States’ industrial renewal and U.S. global power, but good for bonds. Simply lifting the debt ceiling after a technical default for a day? Possibly good for bonds too … as a missed payment on a short-dated bill doesn’t imply a technical default on any of the coupon bearing securities.
But there should be no doubt that governing through taking one of the United States’ most precious assets—the full faith and credit of the union—hostage for short-term political advantage ultimately is inconsistent with the dollar’s current role in the global financial system and the United States’ broader global position.
The recent deal to suspend the debt ceiling is thus welcome. But voters and investors around the world should hope that the U.S. Congress eventually sees the wisdom of dropping the debt ceiling altogether, and automatically authorizing the Treasury to borrow the funds needed to meet any lawful budgeted spending. Repeated brinksmanship is costly; well-governed countries don’t need the risk of a global financial catastrophe to agree on a budget.
An American political union that pays its bills—and that can govern responsibly when an election results in a split of power—will remain a preeminent global power for a long time. A house so divided among itself that it cannot agree to pay the debts incurred for lawfully authorized spending will not long stand.
This post was written for the Council on Foreign Relations’ Renewing America Initiative—an effort established on the premise that, for the United States to succeed, it must fortify the political, economic, and societal foundations fundamental to its national security and international influence. Renewing America evaluates nine critical domestic issues that shape the ability of the United States to navigate a demanding, competitive, and dangerous world. For more Renewing America resources, visit https://www.cfr.org/programs/renewing-america and follow the initiative on Twitter @RenewingAmerica.
