Failure to act on debt could spell trouble for economy

The government has maxed out its borrowing limit, and Treasury officials have warned of dire consequences if Congress and the White House can't agree soon on a plan for raising the debt ceiling.

Failure to act on a plan could force the Treasury to make steep spending cuts to avoid defaulting on debt payments, with potentially serious damage to the current weak economic recovery.

The Senate this week shot down a proposal by Rep. Paul Ryan, R-Wis., to cut $6 trillion in federal spending over the next 10 years. That put Congress back on square one as lawmakers look for a compromise that would allow the government to continue operating without some kind of automated cuts to stay under the spending cap.

Though the government hit its official $14 trillion credit limit May 16, the Treasury has said it has some wiggle room to remain under the ceiling for the next two months or so.

The biggest fear is that the government won't be able to pay the interest on its existing $14 trillion in debt, but some budget analysts believe that scenario is unlikely.

Interest on the national debt only accounts for about 10 percent of federal spending, and the  government can pay off old bonds that come due with the proceeds of fresh debt sales. (The debt limit only applies to the total amount outstanding.)

There are also a variety of accounting tricks, some never used before, that the Treasury is considering to postpone the day when it runs out of cash. Treasury Secretary Tim Geithner has said the government can free up some $232 billion with what he calls "extraordinary measures." The government has already suspended contributions to federal employee pension funds. It may also stop making payments into a government fund that buys and sells foreign currencies.

The longer the government is banned from borrowing, the more "extraordinary" these measures may get. In some cases, it's not even clear if they would be legal.

By suspending payments, selling off assets or moving funds from one account to another, Treasury officials can buy a little more time. But Geithner has predicted the Treasury will run out of gimmicks by the first week in August.

At that point, without a higher borrowing limit, the government will have a hard time coming up with enough cash to pay its bills. In theory, it could continue to avoid defaulting on Treasury securities by suspending other payments. But the process of managing the government's finances without the breathing room of a higher credit limit won't be easy, said David Greenlaw, Morgan Stanley's chief U.S. fixed-income economist.

"It's important to recognize that the Treasury's cash flow is very lumpy. They have big cash flows in and out in at different points in the month," he said. "So I don't think you can skate by here by skimping on your other payments and paying your debt payments."

Deciding which payments to suspend would not be easy.

The biggest of those include monthly payments to Social Security recipients and Medicare reimbursement for health care providers. Add essential spending for defense, public safety and interest on the national debt and Uncle Sam's minimum obligation rises to more than $130 billion a month, according to a recent analysis by Goldman Sachs economist Alec Phillips.

Once those bills are paid, the Treasury has only enough to cover about 25 percent of all of the rest of its bills, including $40 billion a month in contracts for goods and services, $22 billion in paychecks for federal workers and another $25 billion to state and local governments, according to Phillips.

If cuts were applied at that level, the government would stop paying nearly $19 billion a month to state and local governments, or about $225 billion a year, pushing down the federal budget problem. State governments are already scrambling to close a collective budget gap of $112 billion for the coming 2012 fiscal year, according to the Center on Budget and Policy Priorities. Those cuts are forcing widespread layoffs of government workers, creating one of the biggest drags on the job market.

As spending cuts go deeper, the impact on the economy gets wider. In all, the federal budget deficit is currently running about $1.5 trillion, roughly 10 percent of gross domestic product. Closing that gap all at once would almost certainly drive the economy back into recession. So would a sudden a tax increase to cover the shortfall.

As it is, the economy grew at only a weak 1.8 percent rate in the first quarter, the government reported this week, well below the level normally seen in the early stages of a recovery.

Regardless of what happens, investors will be watching carefully for assurances that Congress and the White House have a credible plan in place to shrink the deficit. Standard & Poor's, the credit rating agency, has warned that without a plan in place by next year, the U.S. government could lose its AAA credit rating, which would raise the nation's cost of borrowing.

If lawmakers fail to come up with a budget agreement, the government could lose the confidence of bond investors well before then.

"It would tell the world that the U.S. can't get its act together, that this is basically a circus," said William Gross, managing director of the world's biggest bond fund, Pimco. "Investors ultimately won't want to be held hostage by a bunch of clowns."