In the early 20th century, Venezuelan dictator Cipriano Castro liked to borrow money from foreign investors. But he didn't like paying them back. Big mistake. In December 1902, Britain, Italy and Germany demanded repayment. To make the point clear, warships from all three nations shelled several Venezuelan forts and blockaded the country's ports. Caracas paid up.
Should Washington fail to raise the debt ceiling by Aug. 2 and thus risk defaulting on its financial obligations, the White House and Congress thankfully would not have to worry about gunboats from Europe — or, given who buys U.S. Treasurys these days, from China — appearing off America's shores. Defaults get more civilized treatment these days: Bond downgrades, panicked market sell-offs and emergency meetings of central bank officials have replaced naval bombardments and threats of war.
Nonetheless, a default could still inflict significant — and wholly unnecessary — harm to America's ability to wield and project its power in the world. At a minimum, by driving up the government's borrowing costs, it would intensify pressure to cut defense spending at a time when the U.S. military is engaged in major operations across the planet. Meanwhile, America's adversaries would cheer Washington's unforced error as proof of their narrative that the United States is a fading power.
The precise consequences of a default would depend in part on how it happened and how long it lasted. Although few remember it now, the United States had a brush with debt default in 1979. Back then, the Carter White House and Congress took so long to strike a deal on raising the debt ceiling that the government was late in paying holders of Treasury bills.
The world might again shrug off a similar “technical default” in 2011, but one lasting several weeks or longer would be new territory for an advanced Western democracy. In the seven decades since World War II, no such country has defaulted on its debt. Russia defaulted on its loans in 1991 and again in 1998, but at the time, its economy was struggling to make the transition to capitalism, and its international clout had long been in decline.
In short, we are in uncharted waters. No Western major power in recent memory has taken a manageable fiscal problem and turned it into a crisis.
So what is likely to happen? A sustained default could undercut American power in four ways. The first and perhaps most certain would be to force cuts in defense spending. Luring lenders back to Treasury's auction window would require offering higher interest rates. It is estimated that the 1979 technical default pushed up the federal government's borrowing costs by about half a percentage point for much of the next decade.
A half-point increase may sound like small change, but spread across trillions of dollars in debt, it is big money. The Congressional Budget Office reported in February that raising interest rates a third of a percentage point over its base-line estimate could add $1.1 trillion in additional interest expenses over the next decade, if the interest rate environment mimics that of the 1990s. Different assumptions would lead to a higher or lower projection, but all predict a bigger burden on the federal budget.
If tax increases are a non-starter, the only option for shrinking the deficit would be cutting spending. Defense would not escape the budget ax, for the same reason Willie Sutton robbed banks — that's where the money is.
Defense cuts would mean a smaller, less capable military. The armed services, already overstretched, would probably have to reduce troop levels. Navy and Air Force plans to recapitalize aging fleets of ships and planes would probably be scaled back, resulting in fewer of them at a higher individual cost. That would leave the United States less prepared to defend freedom of the seas and the air, or to meet potential threats from Iran, North Korea and elsewhere.
Second, a default would make it harder for Washington to negotiate agreements or build alliances with other countries. Foreign capitals would conclude, not without reason, that bargaining with the White House would be a waste of time. A president who cannot persuade Congress to do what its leaders say needs to be done is not going to win passage of a new arms-control agreement or trade deal. And while President Obama's critics might cheer his loss of global clout, skepticism about what presidents can deliver in a poisonous domestic atmosphere would probably dog his successors as well.
Third, a debt default would erode American soft power. The collapse of Lehman Brothers in 2008 raised doubts around the world about the wisdom of the U.S. economic model. A debt default would not only compound those fears, but would also raise similar doubts about the viability of the nation's political model. A country that lectures others about their problems but cannot fix its own hardly inspires emulation.
China, Russia and America's other “frenemies,” not to mention its outright adversaries, would try to maximize the damage from a debt default. They would repeat the claim they have made for years — that America is in decline, and that their own political and economic models are ascendant — and now they would have a vivid example.
The United States would remain the world's most powerful country for years to come, even in the event of a default, but in diplomacy, perception often is reality. Countries that now look to Washington for leadership and protection could decide that they're better served currying favor with Beijing and other capitals.
Finally, a default poses one risk that could rewrite the rules of American foreign policy. More than just tarnishing the promise of “the full faith and credit” of the U.S. government, a default could help China, Russia and other major buyers of U.S. debt accomplish something they have been trying to do for years: find an alternative investment to U.S. Treasurys.
Now, when there's trouble overseas — such as political turmoil in the Middle East or rising tensions on the Indian subcontinent — foreign capital floods into the United States, seeking a safe haven. That pushes down interest rates and spurs the U.S. economy. But should capital start flowing out of the United States when crises occur, Washington would find itself in the painful position of wondering how its actions abroad will affect its finances at home.
Of course, the alternative homes for capital have clear disadvantages, too. The euro zone is struggling with its own debt problems, and no other market offers the size and liquidity needed to serve global capital. Sometimes, however, the unlikely can happen.
It is easy to dismiss the risk of a default, but it could touch off a series of events that the United States would long regret — and would be unable to reverse. House Speaker John Boehner (R-Ohio) hinted as much when, asked what would happen if the United States defaulted, he responded:“I don't know.”
It would be best for American power not to find out.
James M. Lindsay is director of studies at the Council on Foreign Relations and blogs at The Water's Edge.
This article appears in full on CFR.org by permission of its original publisher. It was originally available here.