In case you haven’t heard, the United States is in the middle of a perilous debt-ceiling showdown. Congress needs to expand the amount of money the US can legally borrow, but Republicans and the Biden White House can’t agree on the terms.
That is pushing America closer and closer to the date of default, which means America won’t be able to pay its bills. That would, as you’ve also probably heard, cause economic pandemonium in the United States, but also abroad, potentially triggering a global financial crisis and recession.
Sounds bad — because it is. The US political dysfunction will engulf the rest of the world because America anchors the global financial system. US Treasury bonds and the dollar have traditionally been seen as risk-free. If the US defaults, they won’t be that reliable any longer — but that readjustment can’t happen overnight, either.
The US is already starting to look like a much more chaotic bet. And if America defaults, that could accelerate and have profound implications for the United States’s global influence. US power and geopolitical leverage have very much to do with its financial dominance. It’s how the US can wield sanctions to punish Russia for its Ukraine invasion, or North Korea for its nuclear weapons program. Suddenly, the world looks very different if, say, central banks start buying up more reserves of euros or Chinese renminbi.
To be clear, the world is nowhere near that yet, but as Marcus Noland, executive vice president and director of studies at the Peterson Institute for International Economics said, a US default “gives that process a nice shove.”
Vox spoke with Noland about what we’re actually talking about when we talk about a US debt default causing a global crisis, and what some of the longer-term implications of that might be for America and the rest of the world.
The conversation, edited and condensed for length and clarity, is below.
When we talk about a possible US default, we often say some version of it could cause a “global financial crisis.” What does that mean?
US Treasury bonds act as a kind of risk-free benchmark on which many, many, many, many, many other financial transactions around the world are based, so that your mortgage, or commercial real estate — all sorts of transactions — are linked, ultimately, to the prices for US Treasury bonds, and the interest rates that are implied by those prices.
It can get way beyond just things like mortgages or commercial real estate interest rates, but other kinds of transactions as well. This could be in all kinds of financial markets, and it’s not limited to the United States. There are markets around the world that ultimately are benchmarked against this standard of a risk-free asset.
If that market freezes up and there are no longer transactions [around US Treasury bonds], and those prices are no longer observable, or the markets become so thin and fragmentary that the prices become highly unstable and erratic, that will cascade into other markets. Not only will the US Treasury market itself be affected, but all these other markets that are ultimately linked to it are affected as well.
So the value of other contracts is pinned to the value of the US Treasury bond?
There may be a contract in which the interest rate on this particular contract is some margin above a specific US Treasury issuance. If that US Treasury issuance essentially no longer exists, if there’s no price, then that [other] contract basically has no price.
Once the market for US Treasuries freezes up, then that will have a cascading effect, within the United States, but globally as well, as other financial contracts that are ultimately linked to that risk-free benchmark can no longer function, either.
Essentially, it takes this standard that everyone is using, and it just throws it completely out of whack because you don’t have a fixed point to compare it to — so you don’t even know what you’re supposed to be paying.
Exactly, exactly. You lose that fixed point. That’s a good way of putting it. It would be sort of like if Greenwich Mean Time disappeared. You wouldn’t even know what time it was because everything is measured against Greenwich Mean Time.
Outside of the United States, are there countries or markets or industries that are particularly vulnerable if that were to happen?
I’ve mentioned, obviously, things like housing, commercial real estate here in the United States, but essentially, anybody who holds US Treasuries would be at risk. And that includes foreign central banks, that includes foreign financial intermediaries or American intermediaries that sell services to foreigners based on US Treasuries, or securities that are benchmarked off of US Treasuries. Think of pension funds. Think of banks. I mean, it would be taking the cornerstone out of the entire modern finance global financial system.
It sounds like immediate chaos. What might happen next?
I honestly don’t know what large holders of US Treasuries would do. For example, foreign central banks. You can imagine an alternative system in which bonds issued by the European Central Bank, or bonds issued by the Bank of England, or other major central banks around the world, could start to form that new set of benchmarks. And you could essentially reconstruct contracts, linking them to those instruments as kind of the risk-free benchmark. But there’s a reason why the dollar is, and US Treasuries are, the benchmark, and not the euro and bonds issued by the European Central Bank or the Bank of England or something. In some long-run sense, they might play an equivalent role, but they don’t play that role today.
It’s not like there are no alternatives to the dollar-based system. But the dollar and US Treasuries are the dominant vehicles for this function in the international financial system.
Even if the US does not default, this showdown is coming closer to the edge — and may be a feature, not a bug, of our political system. How do you think that is influencing how the rest of the world thinks about US Treasury bonds and the dollar in the longer term?
The dollar can play a variety of roles, and US Treasuries play a variety of roles. The use of the dollar and US Treasury securities as central bank reserves has been declining over time, but it’s still by far the largest. It accounts for about 60 percent of global central bank reserves, and no other currency comes close. The euro is in second [at about 20 percent]. And then I think after that, everything else is in single digits. So there’s already a trend away from the dollar, but it’s a slow-moving trend.
Likewise, it’s hard to get data on trade invoicing. But the International Monetary Fund and other groups have tried to collect such data. It appears that the dollar is the predominant currency used in international trade. The Chinese are denominating a lot of their trade in renminbi. So that is already rising, and that process is further along. The use of non-dollar currencies for trade invoicing has moved along further than for central bank reserves.
And then you can look at things like: How is it used in portfolio investment around the world? In this situation, of course, people are going to be moving away from the dollar. The question is, how rapidly and to what other alternatives?
Periodically, there has been a thought that some other currency might challenge the US dollar for supremacy. Back in the late 1980s, people thought maybe it would be the Japanese yen. But the Japanese didn’t want to do the things that would be necessary to make the yen more widely used around the world. So that moment passed.
Then the euro was created in 1999. People thought the euro could be an alternative to the dollar. But this was an untested central bank that was governed by a whole group of countries. That’s not the same thing as the US Treasury and the US Federal Reserve. And so while the euro has gained use in all sorts of ways, it has not supplanted the dollar.
Now the interest is with the Chinese renminbi. Here, the story gets more interesting because China is a non-Western country with a set of diplomatic interests and political values that seem to be quite distinct from those held in the United States and the West more broadly. It is thought that the rise of China and the potential use of the renminbi could present a greater political challenge to the United States, which leads to your interest in sanctions and foreign policy.
Yep, let’s talk sanctions.
Because the dollar is the dominant currency, that has implications for United States foreign policy.
The US can use its control over dollar deposits in the United States as a direct lever for sanctions, as we have done in the case of Russia and its invasion of Ukraine.
[The US] can also use the vast and lucrative US financial market as a lever to gain compliance with economic sanctions. For example, in the 2000s, the United States sanctioned a small bank in Macao called Banco Delta Asia, which was a small, obscure bank, but it turned out it was one of only two banks that North Korea used. When the US put sanctions on Banco Delta Asia and got the Macanese authorities to freeze North Korean holdings in the bank, it crippled North Korean international exchange. Ultimately, the Macanese authorities and the People’s Bank of China were willing to go along with this because they took a look around and they said — obviously, I’m making these numbers up for illustrative purposes — “you know, we’re doing $10,000 worth of business with the North Koreans. We’re doing $10 billion worth of business with the United States. We’re going to do the commercially prudent thing and throw this troublesome small customer overboard to maintain access to the US market.” The centrality of the dollar and the size of the US financial markets gives leverage in that regard.
The final way is — and I’m going to use an example with respect to North Korea — when you’re doing dollar transactions, those dollar transactions pass through banks in the United States, and through the US Federal Reserve System. And so we can watch what you’re doing. We can block transactions. We can use all that data, we have to suss out what front companies may be operating to do illicit transactions that we don’t want to happen. When it comes to North Korea and, say, missile proliferation or their nuclear program, we can use our information on dollar transactions to figure out who the front companies are and how they’re linked, and then we can go after them in terms of trying to impede these transactions that we want to stop.
If you have a rise in the renminbi and have the development of alternative messaging systems to SWIFT and those transactions — especially if you have a central bank digital currency, the e-Chinese yuan, and those transactions are going through the People’s Bank of China, they’re not going through the New York Fed, then we can’t see them. And so now, if you’re the North Koreans, and you want to do some nuclear program work or missile proliferation, you can run your transactions through Chinese banks in Chinese currency and never use the dollar, it never enters the American radar system. And so if you’re in the United States, and you want to impede these activities, the rise of the renminbi as an alternative to the dollar can really impede the effectiveness of US sanctions activities.
For all three of those reasons, an erosion of the status of the US dollar and the centrality of the dollar or dominance of the dollar will lessen the ability of the United States to carry out certain forms of economic or financial diplomacy or sanctions policy.
How does the debt ceiling showdown tie into that, exactly?
There’s this massive loss of confidence in the dollar, and massive reappraisal of the riskiness of the United States, and you’re looking around for alternatives.
Now I want to make clear, the renminbi is not going to immediately replace the dollar. The Chinese have capital controls. Their internal financial markets are large, but they’re relatively unsophisticated. If you were a foreign investor, you cannot hedge and swap risk in China like you can in New York. Finally, the issue of lack of constraint on executive authority — maybe we don’t have enough executive authority here — but they have excessive amounts. You might be a little concerned about putting yourself at the whim of Xi Jinping.
So it’s not like the renminbi is immediately going to replace the dollar. But this is more like a self-inflicted thing by the United States, which then encourages people to start looking around for alternatives.
The most likely ones will be the euro and the renminbi. In the long run, we may end up in a situation, such as some people argue we existed in prior to the First World War, where you have multiple currencies all kind of existing together. There’s not a single dominant currency. You could imagine, eventually, in however many years, the dollar, the euro, and the renminbi kind of playing a similar role in the 21st century.
So it’s not like this will happen overnight, but these debt showdowns, and the possibility of default, may accelerate that decline of the dollar’s dominance.
Exactly. It gives that process a nice shove.
What it will do in China is — China, like I said, they have capital controls; their markets aren’t as well developed as ours are; they have an executive that doesn’t have a lot of constraints on his behavior. But China may say to themselves, “This is presenting us with an opportunity. If we start to get rid of the capital controls, if we develop more sophisticated markets, if we tie the executive’s hands more, we may make the renminbi more attractive to others.” So it might also elicit a kind of response within China that would help propel or facilitate the internationalization of the Chinese yuan.
But I wonder, is a global financial market where different currencies have more parity necessarily a bad thing?
No. That’s the world that existed, basically, at the end of the 19th century, in the first stage of globalization, and it seemed to work okay. But it means that the US would have less power and influence.
In a pure economic sense, no: You can have a multi-currency world. The fact that we have vast increases in electronic capabilities and development of digital currencies will reduce the transaction cost of moving from one currency to another. There might be some efficiency gain from having a single currency, but there’s not going to be huge efficiency loss from having several currencies operating in that way.
The big change would be the loss of US geopolitical influence.
Is there anything else about a potential US debt default that you wanted to flag?
I mean, everybody loses.
Low-income countries will be vulnerable because a lot of them borrow in dollars, but everybody will be vulnerable. If you want to bring it home to Americans, you could disrupt their pension systems and pension payments and their mortgage and everything else. And then the foreign policy aspect is the US is advantaged by the centrality of the dollar and our Federal Reserve System in global finance. If that starts to disappear, then our ability to use financial sanctions for things like dealing with North Korea start to erode as well.