Debt ceiling talks entering uncharted waters

President Barack Obama has painted a bleak picture of what could happen to the economy if lawmakers do not agree on a pact to cut the deficit in time to avoid a U.S. default. He warned the economy could slip back into recession and lose millions more jobs.

The reality is that economists don’t know exactly what would happen. What they do know is that we would stray into territory marked “Here Be Dragons” on the economy’s map.

At a news conference on Monday Obama warned that failure to reach a deal on raising the nation's debt limit could "potentially create another recession." He outlined what could happen if buyers of U.S. debt get spooked by a failure to raise the government’s borrowing authority, currently maxed out at $14.3 trillion.

Obama, trying to bring home the potential impact on consumers, warned of a "crisis of confidence in the markets" that could boost interest rates sharply on car loans, mortgages and credit cards.

The Treasury has warned that by Aug. 2 it will be unable to pay all the government's bills. Some budget analysts have pointed out that there is more than enough money coming into the Treasury to pay the interest on existing debt. But without authority to borrow more money, the government would have to stop paying some of its bills.

At that point, the Treasury faces uncharted waters. Though it has some discretion on which bills to pay, much of the federal budget is set by statute. That means Treasury could face legal challenges as it begins holding back payments. Because the government has never had to resort to such measures, there aren’t a lot of precedents to guide government lawyers advising Treasury officials on which bills to stop paying.

Even as Congress and the White House play chicken over the debt talks, financial markets remain remarkably unperturbed at the prospect of a U.S. default. Some investors say that’s because such an outcome is all but unthinkable.

“People just don't see it happening,” said David Zervos, market strategist for Jefferies & Co. “Frankly, it has to be a very remote possibility. The problem is, it has to be a remote possibility because it’s such an unfathomable thing.”

Some market analyst have suggested that financial markets might even maintain equilibrium following a short-term default — if it sparked a meaningful plan to bring the budget back in balance. According to this line of thinking, investors wouldn’t mind waiting a few weeks for the dividend checks on their Treasury bonds if it meant the U.S. government was on a more solid fiscal course.

Even if agreement is reached to raise the debt ceiling, the risks to the economy will remain without a long-term plan to balance the budget. Several agencies have warned of possible downgrades to the United States' sterling credit rating if a debt-reduction plan isn’t in place before the 2012 president election. Such a downgrade would force many investment funds to sell their holdings, because they are required to hold only AAA-rated paper. That would force interest rates higher.

In any case, interest rates are likely heading higher no matter what kind of budget deal is reached. The Federal Reserve, which has cut short-term rates close to zero, will have to begin raising them again at some point. When it does, the cost of rolling over the existing debt will rise, adding a further burden to the federal budget.

"If we go back to the long-term average of over the last 20 years of the interest costs to the Treasury, by the end of the decade we're going to have an extra $850 billion of interest spending per year,” said Lawrence Lindsey, former White House chief economist in the George W. Bush administration. “When talking about deficit reductions like we had this year of $37 billion, the interest cost is going to swamp any gains we make.”