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Debt ceiling negotiators are 'playing with fire'

As the clock ticks down on a possible default by the U.S. government, investors from Wall Street to Beijing are getting increasingly jittery about the rancorous stalemate in Washington.

The stakes involved were brought into sharp focus after two bond credit rating agencies warned that the government's pristine debt rating is in jeopardy unless Congress and the White House make meaningful progress on budget talks before the Treasury runs out of borrowing authority in early August.

"It's a very serious warning," said Roger Altman, founder of Evercore Partners and a former deputy treasury secretary in the Clinton administration. "I think it's a helpful warning because it sends a message to the negotiators in Washington that they are playing with fire. And they better be really careful."

As talks became increasingly acrimonious, the largest buyer of U.S. Treasury debt expressed concerns that inaction in Washington was putting its holdings at risk.

Chinese Foreign Ministry spokesman Hong Lei told reporters Thursday: "We hope that the U.S. government adopts a responsible policy to ensure the interests of the investors."

The U.S. economy "has been doing worse than expected," and Beijing needs to "seriously assess" possible risks to its vast holdings of American debt, added Yu Bin, a Chinese government economist.

Without congressional approval, the Treasury can no longer sell fresh debt to pay off existing bond holders and finance the government's operations, which operate at a deficit currently estimated at $1.4 trillion a year. To keep the government funded through the end of 2012, Congress would have to raise the current debt limit by about $2.4 trillion from the current $14.3 trillion.

Republicans, who took control of the House of Representatives partly because of support from Tea Party activists, say they will not vote to raise the limit unless Democrats, including President Barack Obama, agree to at least an equal amount of deficit reduction over 10 years.

A $2.4 trillion package would help, but it would be substantially less than the $4 trillion needed to get the government back on a sound financial footing. After years of failure to balance the budget, a more modest package may not go far enough to satisfy investors and credit agencies.

One proposal getting traction on Thursday would grant the White House authority to raise the debt ceiling without congressional approval. That would give Republicans political cover because they would not have to vote to increase borrowing. Despite its political appeal in Washington, Wall Street gave it a thumbs down.

"We've gone from this notion of a grand bargain to a notion of a mini-deal, and now we're heading towards just a stopgap," said Mohamed El-Erian, CEO of PIMCO, an investment fund with large holdings of Treasury debt. "A stopgap is the worst possible thing for both parties because it means that every three to six months we're going to have this issue again."

So far, interest rates on U.S. debt have held steady largely because investors have few other places to stash their money. With Europe's debt crisis widening, Treasuries have been seen as something of a safe haven.

But the ongoing budget stalemate has eroded that confidence. By withholding borrowing authority, Congress has increased the risk of a default.

For now, the odds of a default still seem remote. So long as the Treasury makes a top priority of paying interest on the debt, there is enough cash coming in to cover those payments. But there's little debate that the impact of such a default could be catastrophic.

Federal Reserve Chairman Ben Bernanke, addressing lawmakers, warned that failing to increase  the nation's debt ceiling and allowing the nation to default on its debt would send "shock waves through the entire financial system."

"No one can tell me with certainty that a U.S. default wouldn't cause catastrophe and wouldn't severely damage the U.S. or global economy," Jamie Dimon, CEO of JPMorgan Chase, told reporters Thursday. "And it would be irresponsible to take that chance."

Even if the Treasury can afford to make those interest payments, the budget stalemate still poses big risks to the financial markets and economy. Both Moody's and Standard & Poor's warned that the government need not actually default to imperil its top AAA rating. Moody's said that if a deal can't be reached to raise the government's borrowing authority in time to pay its bills, maintaining its top-notch credit rating "would likely no longer be appropriate."

Such a downgrade would likely force interest rates higher, as investors demand a bigger return on what would then be a riskier investment. Many investment funds could no longer hold Treasuries in their portfolios, cutting demand for fresh debt and increasing the supply on the open market.

"The higher interest rates would add to the deficit but also a slowdown in economic activity, by reducing revenues, would also add to the deficit, so it really is going in the wrong direction in terms of fiscal stability," Bernanke told lawmakers Thursday.

Default deniers
Some Republicans argue that the administration is overstating the odds of default, noting that the Treasury has enough cash to service the debt beyond the Aug. 2 deadline.

The issue is complicated by the complexities of government spending and receipts, which don't flow in a steady stream week-in, week-out like a household paying regular monthly bills with a fixed weekly paycheck. The government's cash flow varies widely, with irregular, and sometimes unpredictable, peaks and troughs on both the income and payment sides of the ledger.

It's also not clear exactly how the Treasury will prioritize payments when it finally runs out of cash: there is no precedent for the process. The government could also face legal challenges if it fails to meet certain contractual obligations.

Even if investors continue to buy Treasury bonds at current interest rates, a shutdown of government borrowing could add further headwinds to a weakening economy. Much as state budget cutbacks gave forced widening layoffs, a sharp cut in federal government spending would be felt relatively quickly. Without Social Security checks, retirees would be forced to cut spending. Unpaid government contractors would be forced to lay off workers.

The stalled debt talks "pose a significant risk to the economy and markets," said Jay Powell a visiting scholar at the Bipartisan Policy Center and Treasury undersecretary in the George H.W. Bush administration. "We're on the verge of a national crisis here and it's time to get this done one way or another."