Source: Council on Foreign Relations

Global Aftershocks of a U.S. Debt DefaultWith Republicans and Democrats locked in an ongoing stalemate over how to raise the United States' $14.3 trillion debt limit ahead of the August 2 deadline, the prospect of a first-ever U.S. default is rattling global markets and undermining confidence in the world's leading economy. Uri Dadush, a senior associate and director at the Carnegie Endowment's International Economics Program, says that a protracted default, while unlikely, could have "severe repercussions" for the global economy. Even if an agreement is reached to avoid default, the U.S. faces the possibility of having its credit rating downgraded from its AAA status if it fails to implement long-term deficit-reduction measures. "At some point," Dadush argues, "world financial markets, not to mention political leaders around the world and corporate investors, will want to be reassured that the United States is undertaking very significant increases in taxes and reductions in expenditure."

What are the consequences for the global economy if the U.S. defaults on its debt obligations next week?

If this was a long, protracted event, it would have severe repercussions in the United States and globally. I would certainly expect some effect on the borrowing cost of the U.S. government. It would work mainly through the lower traded value of U.S. securities. Something like $4 trillion of U.S. government debt is owned by China and many other countries – China owns about a quarter– and the value of those securities would be impaired, at least temporarily. There will probably be downward pressure on the dollar. The other effect that could operate would be – if you had higher long-term interest rates over a period of many months – a depressing effect on U.S. demand. Investor confidence would obviously take a hit. And any domestic slowdown would have some negative repercussions on world trade. But I don't anticipate that if the United States does go into default – which may or may not happen – that it can last for very long. I can't imagine that the U.S. government will be in a situation where it's not able to meet its [payment] obligations over a period of several weeks without the political backlash being too big to bear on both parties.

What are the consequences of default for the U.S. as a global economic leader?

This doesn't help its standing in the world. Confidence in the U.S. system of government will be reduced. This does not reassure international investors, who hold a significant amount of U.S. government debt, or those who invest large amounts in U.S. private markets, portfolio investments, and equity investments. However, I don't think a temporary default will fundamentally alter the global economic dynamic. For example, any decline in the role of the dollar as a reserve currency, is driven by much deeper changes—namely, the more rapid growth of the emerging markets, which is a long-term sort of a change.

How does the debt debate affect the United States' role as a political actor on the global stage?

It weakens the United States. But this is hardly new. We are still feeling the aftershocks of a major financial crisis and global trade collapse, in which the United States was very much at the epicenter. The disaster that was caused by subprime lending, Lehman [Brothers collapse], and then all the other chain of events that ensued, obviously had a big impact on the United States' standing in the world. The fact that many emerging markets, beginning with China, appeared to handle the situation much better – and emerge relatively unscathed – contributes to this trend. [The weakening of U.S. global standing] was significantly accentuated by the Great Recession; the theatre over the debt limit is another scene in this five-act play.

How likely is it that the credit rating agencies will downgrade U.S. debt from its long-held AAA status?

Some downgrade of U.S. debt is quite likely; it's a significant probability. The fundamental conditions are there for a downgrade. The United States is already, if you look at the G20 countries, the third-most indebted country after Japan and Italy. But unlike Italy, where the projections are that its debt should stabilize, the United States is on a trajectory of increasing debt, and quite sharply increasing debt, over the next five years or so. But both Italy and Japan are far from an AAA rating. The United States shares an AAA rating with countries like Germany, France, and the United Kingdom, all of which have significantly lower debt levels and a better debt trajectory going forward.

Are we talking about a disaster scenario? No, but it's another scene in the play. It certainly would be strange for the country that owns the world's reserve currency – for which, by the way, there's no clear alternative at the moment– to no longer enjoy an AAA rating. The U.S. status as a safe haven will be eroded—but these are changes that are long-term shifts.

Even if the U.S. does cobble together a plan to raise the debt ceiling before next week, what are the global consequences of the country not implementing a long-term deficit reduction program?

At some point – and sooner rather than later – world financial markets, not to mention political leaders around the world and corporate investors, will want to be reassured that the United States is undertaking very significant increases in taxes and reductions in expenditure. This will be needed in order to stabilize the debt level as a share of GDP. The current fiscal trajectory is not sustainable. The United States today is the only advanced country other than Japan – which is in terrible shape – that has not really grasped the nettle on its fiscal picture following the debacle of the financial crisis. And this is particularly ironic because the United States was at the center of the financial crisis. If the U.S. is to continue to assert its role of leadership in the world, it clearly needs to get its own house in order.

It's important for the United States to reduce its budget deficit, because it is a significant contributor to international tension. The uncertainties over U.S. policy undermine the dollar, and they are part of the reason that you have these big flows of funds into emerging markets that are seen as safer. So if you look at a lot of the issues that are high on the radar screen of the G20/IMF – the global imbalance question, the currency tensions issues, the hot money flows to emerging markets – the U.S. imbalance and uncertainties are major contributors. The United States is at the center of the system. Reducing global imbalances is very much related to changes in the U.S. tax system and changes in fiscal policy – including tax increases and the reduction of wasteful expenditures.