When Will the U.S. Debt Limit Actually Roil Markets?

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The U.S. government reached its $14 trillion borrowing limit today. But the debt ceiling debacle has dragged on for months now, so when does this thing actually hit the fan?

After the debt ceiling is hit, the U.S. can’t legally borrow more money to pay off its debts. But the Treasury department has “emergency measures” it uses to keep paying its bills in the short-term to put off a default, such as underinvesting in government funds like Social Security or delaying debt auctions. Through these measures, Treasury Secretary Tim Geithner has said the government can stave off a default for another eleven weeks, until August 2. During that time, reaching the debt limit is unlikely to cause major market disruptions. But the closer we get to the 11-week mark, the more financial pain Washington’s political haranguing will cause.  Example: when the U.S. reached the debt limit in 1995, bond yields fell for several months before rising slightly during the few months before the debt ceiling was raised. By some estimates, an increase of 25 basis points on Treasury yields resulting from the debt limit showdown could cost taxpayers as much as $500 million more per month.

Still, any severe impact on the U.S. dollar and U.S. debt won’t come for a while, since the U.S. dollar enjoys the “exorbitant privilege” of being the world’s reserve currency.  That privileged position is unlikely to change anytime soon, given the ongoing troubles of the dollar’s nearest substitute, the euro, and countries’ growing reserve needs as the global economy recovers. The dramatic growth in foreign ownership of U.S. Treasuries over the past two decades — which increased from 37 percent in 1997 to 57 percent in 2010 — has been driven entirely by government purchases, especially China’s (which uses its dollar reserves to manage its currency value).

Competitive pressure from China has driven other East Asian countries to limit their currencies’ appreciation against the U.S. dollar, again boosting demand for U.S. reserve assets.  Rumors abound about China’s moves to diversify away from the dollar, but its recent purchases of Japanese, Korean, and Spanish debt are mere distractions. The U.S. Treasury market is still the only one big enough to house its enormous dollar holdings. Take the reactions to S&P’s downgrading of its U.S. debt outlook. No headlong sell-off there. The Japanese government said U.S. Treasuries remained “attractive,” and China merely told the U.S. to keep its investors’ interests in mind. Today’s news of over Dominique-Strauss Khan’s sexual deviance will further insulate the dollar by throwing all eyes back on the eurozone’s political and economic troubles and away from the U.S.

That said, the U.S. cannot rely on its global reserve status forever. In a recent study by the McKinsey Global Institute, less than 20 percent of business executives expected the U.S. dollar to be the global reserve currency in 2025. But in the meantime, the U.S. debt limit crisis won’t look anything like the chaos in Europe, so long as U.S. politicians demonstrate their ability to cooperate. (And hopefully they will. Even House Speaker John Boehner said Sunday he doesn’t want to “wait until the eleventh hour.”) The eleven-week window should offer Washington a fairly low-cost environment to strike a deal that calms global markets for good. Or at least until a good alternative to the dollar comes along.