How a debt default could bring down the dollar

Congressional Republicans are playing Russian roulette with America's primacy in the global financial system

By Mike Lofgren

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(George Wylesol for The New York Times)
(George Wylesol for The New York Times)

Published: Fri 12 May 2023, 9:04 PM

Last updated: Fri 12 May 2023, 9:05 PM

Since 1960, Congress has acted 78 times to increase the statutory debt limit to avert a government default. Indeed, when I worked in Congress, from the mid-1980s to 2011, after a bit of posturing, Congress always increased the debt ceiling — and created the expectation that debt-limit fights were a seasonal Washington ritual, like the cherry blossoms or the Marine Corps marathon, of no existential importance.

But lifting the debt is no longer more or less routine, especially when Republicans control the House. That is the case now: The Tuesday meeting between President Biden and Speaker Kevin McCarthy reportedly produced no movement on how to end the impasse over the federal debt.

Attitudes about what a sovereign default would mean seem to have changed among some House Republicans, who are holding hostage the full faith and credit of the United States. They often confuse the debt-limit vote with a government shutdown or have convinced themselves that a sovereign default is no big deal.

They might consider another scenario: A debt default could threaten the dollar’s status as world reserve currency. Indeed, with their risky posturing, congressional Republicans are playing Russian roulette with America’s primacy in the global financial system, a privileged position undergirding our standard of living and international influence.

The only beneficiaries of default would be adversarial actors like Russia and China. To avoid even the possibility of this outcome, President Biden would be well advised to take all available measures to avert such a calamity.

The ideological extremism of the House Republicans is infamous; they passed a bill that “solves” the crisis by nullifying much of Mr. Biden’s agenda and forcing spending cuts of as much as 20 percent on some agencies while conveniently teeing up yet another debt crisis before the 2024 election.

A sovereign debt default has always alarmed economists, who detail a range of damaging scenarios that could spell turmoil: recession, a drop in the dollar that would further spike inflation amid rising interest rates, a plunge in equities, a halt in Social Security payments and panic in money market funds. Banking liquidity would also be at significant risk in the wake of the collapse of First Republic Bank, the second largest American bank failure in history.

But apparently these concerns, as dire as they are, don’t alone move some House Republicans. So they might also consider another potential scenario: Ever since President Richard Nixon de-linked the dollar from gold, doomsayers have predicted the imminent demise of the dollar as the world reserve currency. This prophecy has to date proved wrong; the dollar’s dominance is hardly less than it was in Nixon’s time, and it actually strengthened its safe-haven status during the pandemic.

Having the world reserve currency has allowed the United States to run very large budget, merchandise trade and current account deficits for decades. The dollars flowing abroad as a result of those deficits are needed by other countries to purchase commodities like oil and to conduct other trade. Nations with dollar surpluses can’t sit on them; they recycle them as investments in the United States. That is why New York has the most liquid financial markets in the world. These strong markets in turn encourage many foreign central banks to hold their assets in New York as well.

Adversarial states like China and Russia have been attempting for years to dethrone the dollar as the world reserve currency, so far with meager success. The fact that most international financial settlements are cleared in dollars, just as the SWIFT international transaction network is dominated by the United States, makes Washington’s economic sanctions on rogue regimes a real threat.

Convenient economic arrangements like the dollar’s global primacy are sufficiently stable and “locked in” that we might be tempted to think they are eternal. By this logic, if a default occurs, the money centers in Europe and East Asia will shrug it off and make dollar transactions and purchase U.S. debt instruments just as before.

But as with the British pound, the world currency until World War I, international willingness to use a currency works until circumstances dictate otherwise. A default is unlikely to bring instant Armageddon, but it is possible, perhaps even probable, that it would contribute to a slow unraveling. Foreign investors would begin to hedge on buying U.S. debt, or explore using the euro or a basket of stable currencies. Following a default, oil exporters would be more likely to accept payment in instruments other than dollars.

The consequences of a default in 2023 would probably be more serious than economists have predicted for past political deadlocks. The world has seen three years of pandemic, along with supply-chain disruptions, global inflation, a world splitting into hostile power blocs and a major European war that has no end in sight. U.S. sovereign default could be the culmination of a world “polycrisis,” a word that refers to the current swirl of global emergencies.

A post-default US economy would have to retrench, as enormous trade deficits could no longer be absorbed by the rest of the world. America would need more income from exportable manufacturing and services, whereas consumption would have to be curtailed. In short, the American standard of living would probably drop until domestic production and consumption came into balance.

America’s international leadership for 75 years has in part rested on what many call the dollar’s “exorbitant privilege.” As with Britain’s retreat from empire after World War II, balance of payments problems could make U.S. global dominance an unaffordable luxury.

In December, the Chinese president, Xi Jinping, met with Mohammed bin Salman, the de facto ruler of Saudi Arabia, and discussed the possibility of China settling its oil bill with its own currency. This March, China and Brazil agreed to abandon the dollar in bilateral trade. Should the United States default, such deals could become templates for a broader international move from the dollar.

Constitutional experts have urged the president to invoke the 14th Amendment to require the Treasury to pay legal debts and underscore the inadmissibility of default. Mr. Biden’s advisers appear divided on the issue, but the consequences of default are so grave that, if needed, Mr. Biden must, like Lincoln, ignore fainthearted counsel and use the tools at hand to safeguard the vital interests of the country.

This article originally appeared in The New York Times.

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