What Happens to the Global Economy if the U.S. Defaults? ‘Not Much,’ Say Some Economists

Predictions about the potential effects on the global economy of a U.S. default have verged on the apocalyptic. This weekend, World Bank President Jim Yong Kim characterized the possibility as "disastrous" for both the developing world and developed economies, while International Monetary Fund Managing Director Christine Lagarde argued that a default "would mean massive disruption the world over." Financial leaders speculate that a failure to raise the debt ceiling could trigger higher interest rates, stalled growth, or even a global recession reminiscent of (or worse than) the one caused by the collapse of Lehman Brothers in 2008.

But not all economists are ready to jump on that bandwagon (which is not to say that they necessarily sympathize with the GOP’s vocal camp of "default deniers"). Some maintain that a partial, or technical, default (meaning the government would pay some of its debts late) would be short-lived, if still potentially catastrophic. And others argue that the consequences of such a default would be much tamer than headlines suggest.

Analysts at the London-based global research firm Capital Economics, for instance, assert that speculation about the effects of U.S. default "is surely overdone," adding that "the fall-out should be limited and far less severe than that which followed the collapse of Lehman Brothers" so long as the default does not reflect the U.S. government’s "fundamental inability to pay."

"The crucial difference is that the US government would still be a going concern, with all the tax and spending powers of a sovereign state," the firm wrote last week. "Once the politicians reach a deal, there is no doubt that the US could return to servicing its debts as usual. What’s more, whereas the failure of Lehmans came out of the blue, global policy-makers and market participants still have some time to prepare for a potential US default." While Treasury yields and borrowing costs would almost certainly rise, they argue, this would not necessarily hurt the global economy.

China and Japan, which respectively hold $1.28 trillion and $1.14 trillion in U.S. Treasuries, have voiced concern over how a default could impact their considerable investments. But Capital Economics’ Andrew Kenningham told Foreign Policy that even they "would not be too badly affected provided the U.S. government does pay in full in the end." He added: "The renminbi value of reserves [held by the People’s Bank of China] is always changing in value in response to exchange rate movements and the mark-to-market value is always changing in response to movements in bond yields. So a rise in yields and accompanying fall in prices for a portion of these reserves, for a short period, would not have an out-of-the-ordinary effect."

Roger Altman, a former deputy secretary of the Treasury Department, has similarly argued that a short-term default would do minimal damage. "We’re not likely to see more than a passing impact on the economy or on financial markets," he told Bloomberg earlier this month. "There’s nothing historical to suggest that however ugly and noisy and frustrating this situation is, that there will be any permanently lost output, any permanently lost growth, or incomes or asset values."

It’s still an unpopular position: In a recent IGM poll that asked whether a U.S. default would cause "severe economic harm," only one out of 36 economists — Pinelopi Golberg of Yale — replied that such an outcome was unlikely (provided that a default were reversed within a week). 

And that’s the key takeaway: The shorter the default, the more limited the damage. The real threat to the global economy would be a prolonged default that plunges the United States into another recession. This is the outcome that most concerns global leaders — but one that seems unlikely (though not impossible) to analysts at Capital Economics.

At the World Bank and IMF meetings this weekend, Asian bankers and traders were reportedly nonplussed by the threat of default, with one banker remarking, ""The prevailing view in the market is that someone in Washington will blink and this will all blow over." And if they don’t blink? The key question will be just how long Washington’s warring factions stare each other down.