Commentary: Why the debt ceiling impasse raises real prospect of US default

If investors around the world thought that the full faith and credit of the United States was not being backed up, if they thought that we might renege on our IOU's, it could unravel the entire financial system, Obama said in a town hall meeting over the weekend.

We could have a worse recession than we already had, a worse financial crisis than we already had, said Obama, who famously voted against a proposal to raise government debt ceiling in 2006.

According to the U.S. Treasury's projections, government debt will hit the ceiling on Monday, making it necessary for the Congress to raise the limit, lest the government defaults in debt servicing.

Obama had opposed a similar plan in 2006, saying “the fact that we’re here today to debate raising America’s debt is a sign of leadership failure.” He also said by raising the debt ceiling, the government was shifting the burden of bad choices today onto the backs of our children and grandchildren.”

However, right now the President and the ruling Democrats have run out of options and have called for raising the ceiling. The current debt ceiling is $14.3 trillion, which was fixed in February 2010.

Though the Treasury calculates that the debt has hit that ceiling, it could fend off default until early August by working around funds. The current ceiling of $14.3 trillion is the amount of debt the U.S. government can raise legally, and it includes money the Treasury owes to government trust funds like Social Security.

While some economists consider the very idea of a debt ceiling as strange, public opinion is sharply divided over whether the Congress should raise the limit or let the government default.

If the U.S. allows a default, it will shatter the markets given that U.S. Treasuries are seen as the most sought after assets in financial markets. Treasuries are held by investors and central banks around the world, and a default on it will hit the markets like nothing else can. Even talk that a default is probable can spook the markets, it is argued.

On the other hand, those who insist that a default is the not the end of the world say that it's the bitter medicine required for curing the propensity of the government to ramp up spending indiscreetly.

The republican opponents of the plan to lift the ceiling insist that the government should first commit to massive spending cuts and vouch for fiscal prudence. Some economists support this line, saying that a default will instantaneously solve the debt crisis inasmuch as it neutralizes the government's ability to raise funds to fill the revenue-spending gap. However, this is quite a radical line of thinking and many experts have pooh-poohed this proposition.

The two sides have locked horns on the debt ceiling issue, but no unanimity has been reached so far on how to tide over the fast approaching crisis.

The U.S. House Speaker John Boehner has made it amply clear that before the Republicans offer a lifeline to the government, the Democrats would have to agree to trillions of dollars of spending cuts.

It's true allowing America to default would be irresponsible ... But it would be more irresponsible to raise the debt ceiling without simultaneously taking dramatic steps to reduce spending and reform the budget process, Boehner said last week.

Tea Party leader and likely presidential aspirant Michele Bachmann has been most critical of the plan. Bachman, who leads the House Tea Party caucus, ha said the administration should repeal the famed Obama Healthcare legislation in order to secure support on raising debt ceiling. But the democrats would never toe that line.

It's time to reject the debt ceiling scare tactics and address the truly frightening reality that our debt is at $14 trillion and growing, she said.

The Democrats aver that the republican opponents are endangering the country’s credit rating by refusing to raise the debt limit.

A U.S default was not just unlikely, but also unthinkable some time ago, but the prospect is now discussed more freely on media thanks to the Tea Party influence. Some republicans and their economist sympathizers have been championing more vociferously for a default rather than lifting debt limit, many commentators have noted.

... it is becoming increasingly common for the idea of default to be discussed as a realistic possibility even by responsible analysts, Bruce Bartlett wrote in capitalgainsandgames.

According to him a Congress refusal to stamp legislation to raise the official debt limit is the only ticket for the U.S. to a default. Economists have buttressed the point time and again that the chances of a Greece-style crisis is not real as far as the United States is concerned. This is because the U.S. issues the favored reserve currency of the world, a privilege Greece and other possible defaulters don't have. Though the government runs the risk of fuelling inflation by continuing to monetize debt, it can easily steer clear of the road to default that other countries might have to take.

But a default can become a real possibility if the Congress doesn’t act in time to raise the debt ceiling. The government needs to borrow a staggering $125 billion a month to keep meeting is expenses and paying interest on debt. The moment the Treasury runs out of cash to pay the bills, the country slips into a technical default.

It means the wound of default will rather be a self-inflicted one. Historically, the Congress has acted every time to avert a default by raising the ceiling. However, this time round the rancor surrounding the debate is more vicious, with the Republicans showing much more tenacity and single-mindedness in getting the government cut spending massively.