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Debt ceiling brawl threatens economy, consumers

Washington is gearing up for a battle over how many trillions the federal government can borrow to pay its bills, and it's shaping up to be an even bigger brawl than the one just resolved over funding the government for the next six months.

While investors viewed last week's budget brinksmanship as a minor event, they are beginning to grow concerned that many lawmakers and ordinary Americans, fail to grasp the implications of even suggesting the United States would default on its debt obligations.

What is a political football to Congress could end up flattening the economy and hurting consumers by lowering the nation's pristine credit rating and sending interest rates sharply higher.

The Treasury is warning it will reach its $14.3 trillion limit on borrowing, known as the debt ceiling, in early May. Instead of a straight up-or-down vote on raising the cap, Republicans are threatening to attach policy measures on issues such as abortion funding and environmental regulation. Such "riders" were the main sticking point's in last week's budget showdown.

Anything that threatens to derail or delay the process of raising the debt ceiling is a red flag for markets. The longer it takes and the deeper the divide in Washington, the more markets will worry that the United States, the world's largest debtor nation, will default on its debt obligations with economy-rattling consequences.

On Saturday, House Speaker John Boehner told reporters that President Barack Obama had asked him for a "clean bill" on raising the debt ceiling.

"Well, guess what, Mr. President, not a chance you're going to get a clean bill," said Boehner. "And I can just tell you this. There will not be an increase in the debt limit without something really, really big attached to it."

Negotiations over lifting the debt ceiling will also be complicated by the debate over bigger spending cuts for the upcoming fiscal year. The White House is expected to offer up its plan Wednesday to cut the $1.5 trillion federal deficit.

Raising the debt ceiling will require the approval of at least some Republicans in both the House and Senate. As the GOP plots strategy, its hard-line stand has strong voter backing.

According to a recent NBC/Wall Street Journal poll, only 16 percent of voters said  Congress should raise the debt ceiling, while some 46 percent said they were opposed. When told that would mean the U.S. could default on its debt, 32 percent supported raising the limit. But 62 percent said they opposed lifting the cap even if it meant the Treasury would not making good on its debt payments.

Story: WH: Obama regrets vote against debt limit

So far, bond market investors apparently are not very worried; the United States has never defaulted on its debt and many have long thought a default unimaginable. On Monday, amid the rancorous aftermath of the budget battle that nearly shut down the government, bond prices were flat.

But some investors are betting that bond prices are headed lower. As the Federal Reserve wraps up a $600 billion round of bond buying designed to keep interest rates low, many investors are wondering what will replace that program when it expires in June. On Monday, the giant investment fund PIMCO, which recently dumped its holdings of U.S. Treasury securities, disclosed that it has gone even further and is now selling U.S. debt short — a bet that bond prices have further to fall.

Falling bond prices hurt more than the investors who hold them. As prices fall, interest rates rise. If they rise too far, too fast, the U.S. economy could face the risk of another recession. Without borrowing authority, the government would be powerless to pay all its bills, much less assemble another stimulus package to revive the economy.

Unlike other developed nations, the United States government cannot borrow money without prior approval from Congress. The legal ceiling on borrowing dates back to the  World War I, when borrowing authority was consolidated under an overall limit. Prior to the change, each round of borrowing had to be approved separately.

The math on when exactly when the U.S. runs out of money is imprecise. Treasury Secretary Timothy Geithner recently told Congress that the department's best guess is that, without higher borrowing authority, spending will exceed available revenues on May 16 or sooner.

Setting the precise date is complicated because the government can only estimate the pace of millions tax payments and spending by hundreds of federal agencies.

Once the limit is reached, the government can probably avoid default for a month or two by choosing which bills to pay in full and which to defer or extend.

Once the hard cap on borrowing kicks in, the Treasury would be forced to suspend some non-interest payments. Those include contributions to various trust funds which, by law, the Treasury can stop funding temporarily. Analysts at Nomura Securities estimated such moves could give the government about $1.1 trillion to work with, postponing default by several months.

Without a firm date, negotiations will be more complicated than the midnight deadline that forced a compromise to keep the government from shutting down Friday.

Unnerving bond investors
But the longer the debate drags on, the more nervous bond-buying investors will get. That could push interest rates higher.

Debt-battered countries like Greece and Portugal have already seen interest rates rise, even though they have not missed an interest payment.

"Imagine if you're sitting in France or Germany or London and see us fooling around with the debt limit and say, 'We may not want to let the government borrow another penny,'" said Steven Rattner, an investment banker who headed Treasury's auto industry task force. "There's going to be a lot of market dislocation, a lot of volatility and lot of worrying."

If the United States ever did miss an interest payment on its debt, there would be little Congress could do to put the financial genie back in the bottle.

"Failing to service or redeem debt would lead to damage cascading though financial markets, as debt-holders would be unable to meet their own obligations," IHS Global Insight economists Nigel Gault and Gregory Daco wrote in a note to clients. "It is hard to think of a bigger self-inflicted wound for a $10 trillion debtor than failing to service that debt."

A default could cause so much market uncertainty it could cause a global financial panic, Geithner suggested last week on congressional testimony.

"Default by the United States would precipitate a crisis worse than the one we just went through," Geithner said. "I think it would make the crisis we went through look modest in comparison."

Federal Reserve Chairman Ben Bernanke told reporters in February a U.S. default would have "catastrophic" implications "for our financial system, for our fiscal policy, for our economy."

For starters, the U.S. would almost certainly lose its Triple-A bond rating, spurring a massive bond selloff and raising interest rates.

The banking system would suffer another major shock as the value of its bond holdings fell. The value of the dollar, which enjoys its unique status as the global reserve based on confidence in the U.S. government's ability to pay its debts, would fall, sending oil prices higher.

The damage to the dollar's value would be difficult to repair, and could make it nearly impossible for the Fed to maintain its policy of low interest rates.

"The United States of America, if we didn't have the dollar as the de facto reserve currency of the world, we'd be Greece," former Treasury Secretary James Baker told CNN Sunday. "I mean, we are broke, bankrupt. Really bankrupt."