It’s yet another case of deja vu as far as the debt ceiling debate goes.
Republicans, who regain control of the House of Representatives in November 2022, have threatened not to allow the debt ceiling to be raised unless they are rewarded with unspecified spending cuts. In doing so, they risk pushing the U.S. government into default.
Brinkmanship over the debt ceiling has become a routine — it happened under the Clinton administration in 1995, then again under Barack Obama’s presidency in 2011, and most recently in 2021.
As an economist, I know that defaulting on the national debt has real consequences. Even the threat of pushing for a U.S. default could have an economic impact. In August 2021, the possibility of a potential default led to an unprecedented downgrade of the nation’s credit rating, damaging the financial reputation of the United States and countless individuals, including retirees.
And that’s just caused by the specter of default. An actual default would be far more damaging.
collapse of the dollar
The most serious consequence could be the collapse of the dollar and its replacement as the “unit of account” for global trade. This essentially means that it is widely used in global finance and trade.
Day in and day out, most Americans may not realize the economic and political power that comes with being the world’s unit of account. Currently, more than half of world trade — from oil and gold to cars and smartphones — is denominated in dollars, with the euro accounting for about 30 percent and the rest in all other currencies.
Because of this dominance, the US is the only country on Earth that can pay its foreign debts in its own currency. This gives the U.S. government and U.S. companies enormous leeway in international trade and finance.
No matter how much the U.S. government owes foreign investors, it can simply print the money it needs to pay them back—although it may not be wise to do so for economic reasons. Other countries must buy dollars or euros to service foreign debt. The only way they can do this is to either export more than they import, or to borrow more dollars or euros in international markets.
The U.S. is not subject to such restrictions and can run large trade deficits—that is, import more than it exports—for decades without the same consequences.
For U.S. companies, the dollar’s dominance means they are less exposed to currency risk than foreign rivals. Exchange rate risk refers to how changes in the relative value of currencies can affect a company’s profitability.
Because international trade is typically denominated in dollars, U.S. companies can buy and sell in their own currency, something foreign competitors cannot. It sounds simple, but it gives American companies a huge competitive advantage.
If Republicans push for a U.S. default, the dollar could lose its status as the international unit of account, forcing governments and companies to pay international bills in another currency.
lost political power
Since most foreign trade is denominated in U.S. dollars, the trade must at some point go through a U.S. bank. This is an important way that dollar dominance has given the United States enormous political power, especially to punish economic rivals and unfriendly governments.
For example, when former President Donald Trump imposed economic sanctions on Iran, he denied the country access to U.S. banks and dollars. He also imposed secondary sanctions, meaning non-U.S. companies doing business with Iran were also sanctioned. Given the choice to use the dollar or trade with Iran, most economies in the world would choose to use the dollar and abide by the sanctions. As a result, Iran fell into a deep recession and its currency plummeted by around 30%.
President Joe Biden has taken similar steps in response to Russia’s invasion of Ukraine. Restricting Russia’s access to dollars helped push the country into a near-depression recession.
No other country today can unilaterally impose this level of economic pain on another country. All the President of the United States needs right now is a pen.
Another consequence of the dollar’s collapse will be to strengthen the position of America’s arch-rival for global influence: China.
While the euro may replace the dollar as the world’s primary unit of account, the renminbi will come in second.
If the renminbi becomes an important international unit of account, it will enhance China’s international standing economically and politically. In fact, China has been working with the other BRICS countries — Brazil, Russia and India — to accept the yuan as a unit of account. A U.S. default would bolster that effort as the other three countries are already unhappy with U.S. economic and political dominance.
They may not be alone: Saudi Arabia recently expressed a willingness to trade some of its oil in currencies other than the dollar — a change in long-term policy.
In addition to its impact on the dollar and the economic and political influence of the United States, a default will be deeply felt in many other ways and by countless people.
In the U.S., where tens of millions of Americans and thousands of companies that rely on government support could be affected, the economy could well be in recession — or worse, as one is already expected to be soon. Additionally, retirees may see their pensions shrink in value.
In fact, we really didn’t know what was going to happen or how bad it was going to get. The size of the damage from a U.S. default is difficult to calculate in advance because it has never happened before.
But there is one thing we can be sure of. If Republicans take their default threat too far, America and Americans stand to lose enormously.