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The debt crisis and its potential fallout

As the clock ticks toward next week's deadline set by the Obama administration for raising the $14.3-trillion (U.S.) debt ceiling, collars are tightening in Washington, capital markets are becoming more volatile, and pundits of all political stripes are ratcheting up the rhetoric.

According to some, the financial world as we know it will come crashing down if no debt deal is signed, sealed and delivered by next Tuesday. But others, like U.S. Secretary of State Hillary Clinton, are essentially telling the rest of the world to relax: The politicians will set aside their typical Washington posturing in time to reach a compromise and lift the cap. But if intransigent Democrats and Republicans refuse to budge, the world's biggest debtor will be sailing into uncharted waters.

What happens if the debt ceiling is not raised by the Aug. 2 deadline?

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Global markets are already battening down the hatches in advance of the potential storm. Margins have been raised slightly on debt-related instruments in the futures market and the price for insuring U.S. debt in the credit default swap market has climbed to the highest level in a year and a half. But apart from a nasty market reaction if the worst comes to pass, there would be little other fallout, at least in the short term. The government is not going to have to call on the International Monetary Fund for a bailout on Aug. 3, and it will not default on any of its bond obligations. The U.S. Treasury has several money-raising options in times of emergency, and it has undoubtedly examined all of them, despite frequent denials that there is a plan B.

After all, the Treasury actually hit the ceiling in mid-May. Existing tax and other revenues are enough to cover more than half the government's expenses, including its most pressing obligations - interest on the debt, Social Security, Medicare and military expenditures. The Federal Reserve can also dip into its hoard of about $2.6-trillion worth of Treasury bonds and other securities on its balance sheet to absorb whatever extra money the Treasury has to print. And the Treasury itself holds billions worth of mortgage-backed securities, as well as close to $400-billion in gold that it could sell or swap with the Fed.

What will the rating agencies do?

Any hint that Washington will not be willing or able to meet all of its bond obligations would almost certainly trigger rating cuts. Loss of its sterling Triple-A rating would not, by itself, trigger a widespread selloff of Treasury bonds. But it could add even more billions to the U.S. debt load, as investors demand higher premiums to hold U.S. assets. The higher costs would cascade down to U.S. corporations and even to individual consumers faced with renewing mortgage and other debt. That said, the rating agencies are likely to downgrade the United States at some point anyway, because of its soaring debt and deficits, even if there is no risk of default.

What would happen to the economy?

The impact could be severe and widespread if Washington delays social spending, halts less-essential services, stops paying military personnel, or postpones deals with outside contractors. Faced with higher borrowing costs and dimmer economic prospects, already-cautious corporations would curtail capital spending plans. Unemployment could worsen and the U.S. could be plunged back into recession. The fragile global economic recovery would not be able to withstand such strong U.S. downdrafts.

What political fallout should we expect?

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Ask most Americans, and they will say the debt ceiling is too high already. And political gridlock has become an accepted way of life in Washington. But once cheques start being delayed for everything from Social Security to government salaries, outside contractor and vital state transfer payments, both political parties will have a lot of explaining to do to aggrieved constituents. The economic decline stemming from a sharp reduction in government social spending, and any cutbacks in public services, will turn into a destroyer of political careers for Democrats and Republicans alike.

Why worry so much about borrowing limits? Can't the Treasury just print its way out of this mess?

Always a tempting solution for deadbeat sovereign borrowers; and the devalued U.S. dollar that would result would probably be good for the trade balance. But the country would end up deeply tarnished in the global community. And the resulting surge in inflation would inflict more damage on the U.S. economy than would a temporary cutback in government spending.

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About the Author
Senior Economics Writer and Global Markets Columnist

Brian Milner is a senior economics writer and global markets columnist. In a long career at The Globe and Mail, he has covered diverse business beats, including international trade, the automotive industry, media, debt markets, banking and the business side of sports. More

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