US debt showdown: In the eyes of the world, the damage is already done

US politicians appear to have found a way to avoid going over a cliff and creating a US government default. But the rest of the world is taking note of how the US plays with financial fire.

Is the US dollar's position as the reserve currency of the world imperiled as a result of the debt limit showdown in Washington?

The argument for "yes" has already grown stronger as a consequence of Republican use of the debt ceiling – which needs to be raised in order for the government to pay existing debts and other commitments like funding social security and medicare – as leverage to demand budget changes.

The federal government has been shut down for over two weeks now and the US Treasury says it may run out of money after midnight if a deal isn't struck in Congress. That looming deadline, which could trigger a default that would have catastrophic consequences for the US economy and all the foreign governments who have treated US bonds as the safest of safe havens in an uncertain world since World War II, is likely to focus the minds of US politicians. So a decision to avoid this self-inflicted wound is probably more likely than not (in the early afternoon, Senate Republicans said they've found a way to strike a deal.)

But the tragedy of default averted doesn't mean there's no tragedy. There's an argument to be made that profound damage has already been done to America's financial standing in the eyes of the world. The simple choice of dancing right up to the blink of the cliff over what looks like the pettiest of politicking to foreigners has sent a message that the assumption that US treasuries are a rock-solid place to park your money needs to be reevaluated.

To be sure, the US has defaulted before. After British troops sacked Washington during the War of 1812, the US government defaulted in 1814. And in 1979 the US briefly defaulted due to paper work error – though the error was quickly rectified.

But a political choice to default, enabled by a harshly divided House and Senate, was until now unthinkable. Financially, the US and its elected leaders were the grownups in the room, aware both of the advantages America's preeminent position provides in cheaper borrowing and the responsibility for the health of a globalizing financial system. That assumption can be no longer made.

Michael Casey at the Wall Street Journal writes today that the US no longer deserves its gold standard AAA credit ratings from agencies like S&P, Fitch, and Moody's. He tells of how BlackRock Inc. CEO Laurence Fink, whose firm – the largest money manager in the world, with $4 trillion in assets – told a conference last week that the US is not a “principled nation.”

When men and women who control tens of trillions of dollars in US investments are indicating they’ve lost their faith in America, it goes to the very question of whether the US deserves to be at the center of world finance. So, whether or not Fitch Ratings follows through on the “Negative Watch” status that it placed on its top-notch US rating Tuesday, it’s clear now that the dysfunctional American political system no longer justifies a Triple-A rating from anyone.

It matters not whether the US is actually forced into a devastating default – still an extremely unlikely event. Triple-A credits do not behave like this.

In top-rated countries, politicians do not use instruments like the federal debt ceiling as an extortionist political tool. In allowing that to happen, the US is abrogating its responsibilities as issuer of the world’s reserve currency and as protector of the “risk-free rate.”

Rock-ribbed American capitalists like BlackRock's Mr. Fink aren't alone. Over the weekend, the Chinese government news service Xinhua ran a commentary arguing "it is perhaps a good time for the befuddled world to start considering building a de-Americanized world." The piece is filled with pot shots at America's standing in the world that are standard for Xinhua, but also reflects the real concern that the US and its rogue politicians are no longer safe trustees of the global financial commons.

Most recently, the cyclical stagnation in Washington for a viable bipartisan solution over a federal budget and an approval for raising debt ceiling has again left many nations' tremendous dollar assets in jeopardy and the international community highly agonized.

Such alarming days when the destinies of others are in the hands of a hypocritical nation have to be terminated, and a new world order should be put in place, according to which all nations, big or small, poor or rich, can have their key interests respected and protected on an equal footing.

... What may also be included as a key part of an effective reform is the introduction of a new international reserve currency that is to be created to replace the dominant US dollar, so that the international community could permanently stay away from the spillover of the intensifying domestic political turmoil in the United States.

China is believed to have more than half of its financial reserves in dollar-denominated debt – well over $1.5 trillion. The US Treasury said as of July that China held nearly $1.3 trillion in federal government debt, making it the largest foreign lender to the US, closely followed by Japan, with $1.2 trillion. In all, foreign countries have about $5.6 trillion parked in US Treasury securities – something that has helped keep US borrowing rates at among the lowest levels in the world and helped the country weather the economic storm of the past few years. Of late, both China and Japan have been pulling out of US debt at a near-record clip, a reflection of the fact that the assumption that the US isn't crazy enough to default over politics is no longer a safe one.

Reuters columnist Felix Salmon wrote a good piece on the inevitable loss of trust in America on Monday. He rightly points out that "if you really do expect zombies to start roaming the streets the minute that the US misses a payment on its Treasury obligations, you’re likely to be disappointed." Yes, the world will not come to an end. But:

The harm done to the global financial system by a Treasury debt default would not be caused by cash losses to bond investors. If you needed that interest payment, you could always just sell your Treasury bill instead, for an amount extremely close to the total principal and interest due. Rather, the harm done would be a function of the way in which the Treasury market is the risk-free vaseline which greases the entire financial system. If Treasury payments can’t be trusted entirely, then not only do all risk instruments need to be repriced, but so does the most basic counterparty risk of all. The US government, in one form or another, is a counterparty to every single financial player in the world. Its payments have to be certain, or else the whole house of cards risks collapsing — starting with the multi-trillion-dollar interest-rate derivatives market, and moving rapidly from there.

And here’s the problem: we’re already well past the point at which that certainty has been called into question.

There are signs that the ratings agencies, rarely leading indicators, are catching up to this reality. Fitch said yesterday it's considering cutting the US government's AAA credit rating. Why?

"The US authorities have not raised the federal debt ceiling in a timely manner before the Treasury exhausts extraordinary measures. The US Treasury Secretary has said that extraordinary measures will be exhausted by 17 October, leaving cash reserves of just $30 billion. Although Fitch continues to believe that the debt ceiling will be raised soon, the political brinkmanship and reduced financing flexibility could increase the risk of a US default," the agency wrote. "The repeated brinkmanship over raising the debt ceiling also dents confidence in the effectiveness of the US government and political institutions, and in the coherence and credibility of economic policy. It will also have some detrimental effect on the US economy."

S&P downgraded US debt from its highest grade during the last debt-showdown in 2011. Moody's still pegs US debt at its highest rating, and is not currently considering a downgrade.

Make no mistake. If almost any other country in the world had flirted with voluntary default twice in the span of two years (the least debt ceiling crisis was in August 2011), their rating would have been cut already. The US still maintains a preeminent global financial position, and as the travails of the eurozone have shown, there is not as yet a good alternative to the good old greenback.

But other countries are thinking hard about alternatives. Whatever is or isn't resolved in DC today, that is a fact that US and the rest of the world will now have to live with.