Why a US debt default extrapolates to the END of the US dollar hegemony

I previously pointed out from the public choice perspective why a debt default today by the US government is unlikely and has mostly likely been part of the political theatrics in the contest of power.

Politicians will hardly fight for an unpopular cause or principle, particularly against a system deeply hooked on entitlement or dependency programs, which will only cost them their careers and their privileges as political leaders.

The two-day bacchanalia by US equity markets where the Dow Jones Industrial skyrocketed by 434 points or 2.9% is a testament to this chronic addiction to the entrenched debt based entitlement culture. 

There is another major reason why the US the default card serves as another political poker bluff: A debt default extrapolates to the END of the US dollar hegemony.

Writing at the Project Syndicate, economist and political science professor Barry Eichengreen spells out the likely consequences of a US debt default. (hat tip Zero Hedge) [bold mine, italics original]

But a default on US government debt precipitated by failure to raise the debt ceiling would be a very different kind of shock, with very different effects. In response to the subprime disruption and Lehman’s collapse, investors piled into US government bonds, because they offered safety and liquidity – prized attributes in a crisis. These are precisely the attributes that would be jeopardized by a default.

The presumption that US Treasury bonds are a safe source of income would be the first casualty of default. Even if the Treasury paid bondholders first – choosing to stiff, say, contractors or Social Security recipients – the idea that the US government always pays its bills would no longer be taken for granted. Holders of US Treasury bonds would begin to think twice.

The impact on market liquidity would also be severe. Fedwire, the electronic network operated by the US Federal Reserve to transfer funds between financial institutions, is not set up to settle transactions in defaulted securities. So Fedwire would immediately freeze. The repo market, in which loans are provided against Treasury bonds, would also seize up.

For their part, mutual funds that are prohibited by covenant from holding defaulted securities would have to dump their Treasuries in a self-destructive fire sale. Money-market mutual funds, virtually without exception, would “break the buck,” allowing their shares to go to a discount. The impact would be many times more severe than when one money-market player, the Reserve Primary Fund, broke the buck in 2008.

Indeed, the entire commercial banking sector, which owns nearly $2 trillion in government-backed securities – would be threatened.Confidence in the banks rests on confidence in the Federal Deposit Insurance Corporation, which insures deposits. But it is not inconceivable that the FDIC would go bust if the value of the banks’ Treasury bonds cratered.

The result would be a sharp drop in the dollar and catastrophic losses for US financial institutions. Beyond the immediate financial costs, the dollar’s global safe-haven status would be lost.

It is difficult to estimate the cost to the US of losing the dollar’s position as the leading international currency. But 2% of GDP, or one year’s worth of economic growth, is not an unreasonable guess. With foreign central banks and international investors shunning dollars, the US Treasury would have to pay more to borrow, even if the debt ceiling was eventually raised. The US would also lose the insurance value of a currency that automatically strengthens when something goes wrong (whether at home or abroad).

The impact on the rest of the world would be even more calamitous. Foreign investors, too, would suffer severe losses on their holdings of US treasuries. In addition, disaffected holders of dollars would rush into other currencies, like the euro, which would appreciate sharply as a result. A significantly stronger euro is, of course, the last thing a moribund Europe needs. Consider the adverse impact on Spain, an ailing economy that is struggling to increase its exports.

Likewise, small economies’ currencies – for example, the Canadian dollar and the Norwegian krone – would shoot through the roof. Even emerging-market countries like South Korea and Mexico would experience similar effects, jeopardizing their export sectors. They would have no choice but to apply strict capital controls to limit foreign purchases of their securities. It is not inconceivable that advanced countries would do the same, which would mean the end of financial globalization. Indeed, it could spell the end of all economic globalization.

Once the confidence on the US dollar as a global reserve currency collapses, the outcome will be massive protectionism,  a horrific devastation of the global economy, widespread social unrest and worst, this will likely trigger a world war.

But the above doesn’t go far enough. Aside from global central banks taking a hit from their US dollar reserve holdings, the banking system outside the US will also come under duress or face the risks of collapse as the value of US dollar portfolios (reserves, assets and loan exposure) plunge. 

The highly leveraged currency markets itself will likely fail or seize up. The US dollar constitutes 87% of the $5.3 trillion currency market trades a day under today’s circumstances or conditions.

Domestic defaults, considering the  vastly expanded debt levels are likely to explode as financial flows freeze.

This will be compounded by a standstill of trade and economic activities, which should severely affect the the banking system’s loan portfolios.

And the icing in the cake will likely be a crash of financial markets, where financial assets makes up a key part of the banking sector’s balance sheet.

And given the systemic defaults ex-US government bonds are unlikely to function as safehaven too.

As of the 2nd quarter of 2011, US bonds account for 32% of the $99 trillion global bond markets which about half are government bonds.

And there surely will be huge impact on the global derivative market at $633 trillion as of December 2012

In short ramifications from a contagion of a US dollar collapse seems incomprehensibly catastrophic.

Given this scenario, I am not persuaded that ex-US dollar currencies will rise in the face of a US dollar meltdown.

This assumption will hold true only if ex-US banks have been prepared for such a dire scenario which is a remote possibility. 

But the fact that the US dollar remains a major part of the global foreign currency reserve system demonstrates the continued dependency by the world on the US dollar.

The global banking system whose architectural foundations has been built on the US dollar system are likely to disintegrate too along with the US financial system.

In my view, a collapse of the US dollar standard will extrapolate to the destruction of the incumbent paper money standard. The world will be forced to adapt a new currency standard, whether gold will play or role or not is beside the point. 

Yet I would like to add that the US Federal Reserve holds $2.87 trillion of US treasuries according to the weekly updates on the Factors Affecting the Reserve Balances as of October 9th. The accounting entry by the USTs held by the FED are at “face value” which according to them is  “not necessarily at market value”

This also means that the Fed is susceptible huge losses even if the Fed can resort to changes in accounting treatment to evade insolvency.

The bottom line is that if all the FED’s credit easing programs has been meant to shore up the unsustainable debt financed political system anchored on privileges for vested interest groups operating under troika of the welfare-warfare state, crony banking system and the US Federal Reserve, a debt default would essentially negate the FED’s actions, annihilate such political economic arrangements and importantly leads to the loss of the US dollar standard hegemony.

These are factors which the political “power that be” will unlikely gamble with, lest lose their privileges.

Yet given the persistence of the current debt financed deficit spending and other political spending trends, a debt default and a market driven government shutdown signifies as an inevitable destiny.