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Global Unease on U.S. Debt Impasse

Author: Jonathan Masters, Deputy Editor
July 15, 2011

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With the deadline for a U.S. credit default less than three weeks away, President Barack Obama and top Republican lawmakers remain at odds over a deficit reduction plan that both sides view as a prerequisite to any hike in the debt limit. The impasse continues to fuel apprehension within the global financial system, with two of the "Big Three" credit rating agencies--Moody's and Standard and Poor's--considering downgrading the United States (WSJ) from its AAA status. Moody's cited the "rising possibility" the U.S. debt limit will not be raised in time to avoid default. Economists warn that a significant loss of confidence in the U.S. debt market could prompt foreign creditors to unload large portions of their holdings, sparking a sharp increase in U.S. borrowing costs and calling into question the dollar's role as the world's reserve currency.

Most economists agree that the impact of an outright government default would be severe. Federal Reserve Chairman Ben Bernanke has warned a default would usher in a new financial crisis. While some suggest the market still assumes the issue will be resolved, they say a default would do unprecedented injury to the full faith and credit of the United States and roil international markets (DowJones) in a sea of uncertainty.

China, the largest U.S. creditor, has reiterated its call for a swift compromise in the debt talks. Beijing would be particularly exposed to any acute shock to the bond market, with about 70 percent of its $3.2 trillion foreign exchange reserves invested in U.S. Treasuries (Reuters). Historically, the U.S. debt market has been driven by huge investments from surplus countries like China, which have viewed the United States as the safest place to store their savings.

The Economist notes that while a default may not precipitate an immediate sell-off by foreign banks due to a lack of immediate alternatives, the event would discourage future holdings of such magnitude. As the largest economy and home to the world's reserve currency, the United States has traditionally attracted investors looking for a financial safe haven. But some analysts suggest the current fiscal crisis, including the threat of default, could accelerate a shift in the way global capital is allocated (TIME)--away from developed nations like the United States and Japan and into emerging markets such as China and India. The Wall Street Journal reports that in addition to China, investors in Japan, Russia, and a number of Persian Gulf states will increasingly look for alternative investments to diversify their sovereign holdings.

Bill Gross of the investment management firm Pimco writes that global investment managers are keen to punish defaulting countries (WashPost) severely, adding that alternatives like Canada and Germany are only a wire transfer away. He says a default may prompt foreign banks to rethink their currency preferences, jeopardizing the reserve status of the dollar. A 2010 survey by the McKinsey Global Institute found fewer than 20 percent of business executives surveyed expected the dollar to be the dominant global reserve currency by 2025. However, with a systemic debt crisis racking Europe, some analysts claim there is still no viable alternative to the dollar (DowJones) in the short to medium term.

But an impression of eroding U.S. power is already gaining traction. The latest Pew Global Attitudes poll finds: "In fifteen of twenty-two nations, the balance of opinion is that China either will replace or already has replaced the United States as the world's leading superpower." The poll says the "United States is increasingly seen as trailing China economically."

Selected Analysis:

The United States has entered its "own age of austerity," with the solution to country's fiscal woes coming only through long-term spending reductions, particularly in entitlement programs, writes Mort Zuckerman in the Financial Times.

A period of austerity brought on by debt mistakes will have "profound consequences, not just for Americans' standard of living but also for U.S. foreign policy and the coming era of international relations," write CFR President Richard N. Haass and former Deputy Treasury Secretary Roger C. Altman in Foreign Affairs.

This report from the Brookings Institution addresses the nature and quality of U.S. political leadership, the sources of the nation's governance problems, and some strategies to work around them.

The New America Foundation's Maya MacGuineas recommends an immediate increase in the debt ceiling and the negotiation of big budget deal ($4 trillion) that will keep the nation's debt from outpacing the economy.

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