I had a conversation earlier with one of the tutors in my department on the possibility of a US default. He specialises in financial markets and financial crime, so it was refreshing to hear what someone with more experience had to say on this matter. A few things came out of this chat.

The first was that a US default is more than likely to be a considerable event - but we don’t precisely know what’ll happen. The Economist reported that the US had technically been in default at the end of the 1970s, but he couldn’t substantiate that report. The report asserts that the event had raised interest rates on Treasuries by 0.6% - today, that would cost over $80 billion a year extra. However, what is clear is that the likelihood of this happening is now being considered more seriously. Bondholders are not especially worried at the moment, but they have now begun to meet and plan a potential response to a downgrade and a default. As one commentator put it, the possibility has gone from impossible to merely very unlikely. That is an important psychological barrier - in a market full of such lines and barriers, I suspect that it will be very hard for the US to return to the earlier position. 

Second of all, any default and consequent downgrade would be devastating for the global economy - but in particular for China. China holds by far and away the largest share of US Treasuries of any overseas investor. If there is a downgrade, the value of China’s currency and bond reserves will considerably decrease. Given how opaque China’s government and banking system are, the precise implications of this are not clear. What is clear is that a collapse in her reserve values and deep turmoil in her largest export market will significantly damage the Chinese economy. These two countries are locked into a relationship which means that what damages one inevitably damages the other.

Third of all, if the US is downgraded, and companies dump US debt to switch to other AAA rated securities, we tried to figure out who would benefit. The UK and a number of other countries may well find out their AAA ratings become imperilled as a result - we hold $333 billion of US Treasuries and the US was the second largest target for UK FDI in 2009 - and the contagion would likely see our own debt downgraded as British financial institutions took a considerable hit. However, countries such as Japan, Germany, Canada and Australia are likely to see their ratings remain high, and consequently may see borrowing costs plunge as investment funds, pension funds, banks and other institutions rush to hoover up their bonds to keep their AAA stocks full. 

Fourth, we looked at the banking sector. If the US default/downgrade brings down a large investment bank - say, Goldman Sachs - then it will lead to the global financial system imploding in an even more dramatic fashion. As we saw when Lehman Brothers collapsed, the interconnectivity and high speed of financial markets means that the fall of any large bank causes contagion to spread extremely quickly and cause huge amounts of damage. As the tutor pointed out, this is a scenario that is disturbingly easy to occur without a US default/downgrade - all it takes is a large bank, on an unregulated exchange, to fail to meet a margin call (for any number of reasons, from rogue trader to bad positions), leading to the bank closing its doors because it hasn’t sufficient capital to meet the call. Then, the exchange finds itself short of money because of the failure to meet the margin call, and raises the requirement on other traders in the exchange. Now we have a double-edged sword - both the impact of a bank failure and a capital demand from an exchange. It may sound unlikely to some, but this breathtakingly easy - if the Singapore Exchange had been less well capitalised when Leeson brought down Barings, for example. 

In short, the full impact of a US default/downgrade is difficult to see and likely to be extremely complex. Whilst it will hit some economies extremely hard - such as the UK and China - others may find some small reprieve. If the crisis spreads to the banking system in a big way, though, there may be no way out. Of course, the GOP could pull its head out of the sand and cut a deal to save the US - and by extension the world economy - from this unnecessary body blow. We live in hope.