Worst recession, if the US default on its national debt

The US national debt is increasing by $1 trillion every 100 days. At the moment, the debt has reached just above $35 trillion. But will the US ever default on its debt? What happens, if the US defaults on its national debt? Before reading this article, please read US debt crisis explained, then you will understand everything about the US debt and its implications.

History of US national debt

The US hasn’t accumulated this debt in just a few decades. The US has had its debt since its inception. Since then, the US has never defaulted on its debt. In 1979, the US came very close to defaulting on its debt, and it is known as a mini-default caused by a technical glitch.

When a country defaults on it debt

When a country defaults on its national debt, then the country’s currency often loses value rapidly, leading to inflation and a decrease in purchasing power for citizens. It leads to a sharp economic downturn as confidence in the country’s economy diminishes. That country faces issues such as inflation, cost cutting, citizen protests, and riots. We have seen that recently in Sri Lanka.

US dollar’s importance for US debt

When the US defaults on its national debt, then the same will happen with the US as well. But the US has the biggest advantage among all countries in the world. And that advantage is that the US debt is in US dollars, in its own currency.

When it comes to other countries, their national debt is usually in US dollars as well, so if they want to repay their debt, they have to convert their own currency into US dollars.

For example, if India wants to pay back its debt in US dollars, then first India will have to convert Indian rupees to US dollars. For this, India might print more money, which ultimately reduces the value of the rupee. India might raise interest rates in their country, which leads to lesser economic activities in the country.

So to do business with other countries and to do international transactions, each country’s central bank has forex reserves. These forex reserves are in gold, silver, and foreign currencies such as the US dollar, Euro, and Yen.

Dominance of US dollar

The US dollar is the global currency and countries have the majority of their forex reserves in the US dollar. The US dollar is used in 88% of all the currency exchanges in the world. It means whenever there is a currency exchange, such as from Euro to USD, rupee to USD, or yen to USD, 88% of the time the US dollar is one part of the exchange pair. Remaining 12% is with other currencies such as Euro to Yen, rupee, etc.

59% of all foreign currency reserves held by central banks around the world are in US dollars. So the US plays a central role in the global economy. As all the countries in the world need US dollars. These countries also want the dollar to be a strong currency.

What happens if US default on its national debt?

Now the $35 trillion national debt is in the US dollar. The 68% holders of the US debt are domestic investors. And 32% are the foreign investors. So if the US defaults on its debt, that means the US dollar has weakened, and its consequences would be severe both domestically and globally. 

A default will severely damage the credibility of the US government. It will raise doubts on the US government’s ability to manage its finances and honor its obligations. Even if the US recovers from the default, that will still be disastrous. Because once it defaults, it will set the precedent for future defaults. And investors would always think that the US could default again in the future.

The US bond market is the biggest and is worth $55 trillion, and US Treasury bonds are considered one of the safest investments globally. After the US defaults, the confidence in these bonds will be gone, and investors will heavily sell these bonds, causing bond prices to plummet and interest rates to spike. 

Domestic consequences

Domestically, this default will impact the daily lives of US citizens. The US stock market will see a sharp sell-off as investors panic, leading to a significant loss in wealth for individuals and businesses.

The uncertainty and loss of confidence would lead to a reduction in consumer spending, business investment, and overall economic activity, pushing the USA into a severe recession. As businesses face higher borrowing costs, reduced consumer demand, and uncertainty, many would be forced to cut jobs, leading to a significant rise in unemployment.

The default would raise the interest rates, which would make mortgages, car loans, credit cards, and business loans more expensive. Ultimately it will reduce consumer spending and business investment. Expensive mortgages will lead to a decline in home sales and falling property values. Many homeowners could find themselves owing more on their mortgages than their homes are worth. It would create a similar situation like the 2008 crisis but much worse.

Domestic banks and financial institutions also hold large amounts of US government debt. They would also suffer significant losses, potentially leading to bank failures and creating a banking crisis. The banking crisis means there will be a credit crunch where banks become reluctant to lend money.

Global impact of the US default on its national debt

A default means the US dollar has weakened and lost value. A weak US dollar means global investors lose confidence in the dollar as the world’s reserve currency. Which will depreciate the dollar even more. A weaker dollar would make imports more expensive, leading to more inflation, especially of the essential goods like food and energy. 

Those 32% foreign investors who hold the US national debt will start to sell their Treasury bonds. Which ultimately decreases the value and trust in those bonds. Investors will look for safer investments such as gold or other currencies that are least affected by the US dollar, such as Swiss franc.

The US’s default will have a severe impact on the global market as well. It will also trigger panic in global stock markets, causing a decline in stock prices worldwide, wiping out trillions of dollars. 

The recession in the US will also severely affect other countries, especially those heavily dependent on trade with the US. As the US goes into recession, global trade would decrease. It will affect the countries that rely heavily on exporting goods to the US, such as China, Mexico, and Germany, which would face significant economic challenges.

This will lead to a global recession. Central banks and investors around the world will reduce their holdings of US dollars and Treasury bonds. They will find more stable investments such as gold or alternative currencies such as the Euro, Yen, Swiss franc, or even cryptocurrencies. The US dollar won’t be the world’s primary reserve currency anymore, and it will lead to long-term shifts in the global financial system.

Many country’s central banks such as Japan, china’s central banks hold large amounts of US debt in the form of US Treasury bonds. A default would lead to significant losses to these banks, potentially causing a banking crisis. These banks in Europe, Asia, and elsewhere could face severe solvency issues.

Role of World bank and IMF

When any other country defaults on its national debt, the World Bank and IMF help these countries get back on track. But if the US defaults, the International Monetary Fund and World Bank will not be able to save the US. Because the US itself is a major contributor to these institutions.

So if the US default on its national debt, then it will not only be bad for the US, but it will be catastrophic for the whole world. The chances of the US defaulting are less as long as the US dollar is perceived as a valuable currency by the other countries in the world.

Conclusion

So far Saudi Arabia has refused to do oil trades in dollars, threatening the dominance of the US dollar. On the other hand, BRICS countries are also planning to launch their own currency, which will probably be backed by gold. That currency will be a direct competitor of the dollar. And it will reduce the dollar’s dominance. But it will take at least 20 to 25 years for that to happen. 

So overall, as long as the US dollar is strong, the US will not default on its national debt. But the moment the dollar weakens significantly, all of it will come crashing down. So better secure your financial future with good value investments, and to learn more about value investments, subscribe our newsletter on our website.

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