US debt default will cause chaos

Wong Chin Yoong

The world needs to transition to a global monetary system with liquidity provided by a true multilateral organisation, instead of having the US dollar dictate global liquidity. – AFP pic, May 25, 2023.

THE world doesn’t seem too worried about the likelihood of the US defaulting on its treasury debt after June 1.

Although the stock market stumbles on the fear of such a possibility, optimism recovers when talks between House Speaker Kevin McCarthy and President Joe Biden begin.

Market yields of treasury notes and bonds belay no sense of fear. There is no panic selling, no plunge in bond prices, and no spike in yields.

After all, the Democrats and Republicans had always reached a compromise in lifting the debt limit in the past. The market believes it will be so this time, too.

Perhaps stranger to ordinary people, who witness their home currencies depreciate drastically recently vis-à-vis the US dollar without a single clue of its impact, is to realise global investors react to great uncertainty in US politics and economy by running back to the US financial market. 

Risk-on cycle is but for a simple reason: US debt securities remain the most liquid-safe assets in the world.

When you need to park your money in liquid assets in the face of uncertainty, nowhere else compares to the US financial market. Not even the debt limit saga could change this simple fact, at least not yet.

But don’t be fooled by the relative calm. This is a classic example of a tail-risk event – an extremely small probability that brings monstrous losses.

If it does happen, it will sweep through the world as US treasury notes and bonds remain the most important reserve assets, accounting for nearly 60% of the world’s foreign exchange reserves.

And there are a couple of ways the world can suffer. Each is disastrous, and all combined can be cataclysmic.

A default implies vanishing dollar reserves from the central bank’s assets, or to a lesser degree, the increasing probability of default causes bond prices to nose-dive.

Either way, the central banks’ balance sheets turn imbalanced, prompting either a massive devaluation of the nation’s currency that instigates unwarranted inflation and deterioration in terms of trade, or a recessionary deflation if central banks respond by shrinking the monetary base.

Evaporating dollar liquidity also implies the world would encounter mounting challenges in financing short-term debt and imports.

Skyrocketing bond yields would likely be the last straw for poor and developing countries struggling with dollar debt.

As the old saying goes, when the US sneezes, the world catches a cold. Whatever strikes the US economy in the aftermath of its debt default is inevitably going to drown the world.

With interest rates already beyond 5%, the US economy faces a fair chance of a crash-landing following sudden yield spikes.

Banking crises from the plummeting bonds’ market value can easily dwarf the 2008 global financial crisis. The global economy would become collateral damage.

Although the odds of calamity remain tiny, the incident is a red flag on the defect of the current international monetary system – the world relies too heavily on a country’s treasury notes and bonds as reserve assets.

When the supply of treasury notes as reserve assets to the world is dependent upon the budget deficit of the reserve country, the “Triffin dilemma” is revived, as the more foreign reserves the world accumulates, the larger the reserve country’s budget deficits, and the more doubtful the value of foreign reserves. 

The debt limit deal saga only rubs salt into the wound by showing how the provision of global liquidity as a critical global public good can be disrupted by domestic politics under a debt-oriented international monetary system. 

Many would argue the current chaos is proof of the undesired dollar hegemony, and the system needs to transit towards multi-reserve currencies.

While the likely consequence of tail-risk events as such could be moderated in a system with multiple reserve currencies, it invites tail-risk events from other reserve countries.

Sources of disturbance have now become diversified, and the system is exposed to the domestic politics of multiple reserve countries.

As long as the global system remains pivoted to one country’s debt for global liquidity, the power domains of global liquidity users and suppliers would not be completely coherent, no matter how diversified the sources of reserve assets are.

The world needs a transition towards a global monetary system with liquidity provided by a true multilateral organisation. Otherwise, we’re living with a time bomb. – May 25, 2023.

* Wong Chin Yoong is a professor of economics at Universiti Tunku Abdul Rahman, Kampar campus.

* This is the opinion of the writer or publication and does not necessarily represent the views of The Malaysian Insight. Article may be edited for brevity and clarity.

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