If debt ceiling talks yield no deal, how bad for US economy?

If Democrats and Republicans don't agree to raise the national debt ceiling by Aug. 2, economists say the consequences would be swift and severe.

The US economy could plunge into a new recession as the massive daily spending of the federal government grinds to a partial halt. The stock and bond markets would be sent reeling. Interest rates would jump upward, not just for US Treasury bonds but also for other debts such as mortgages and auto loans.

The financial fallout would not be limited to the United States. Even if the "no-deal" period during August were brief, it could have long-lasting negative effects on investor confidence in America's creditworthiness.

All that sounds like an armageddon scenario. But those assessments are widely held by mainstream economists who don't have a partisan stake in the debt talks. They're not saying the world would actually end, but they are warning Washington that jobs and livelihoods – not just political wins and losses – are at stake.

"Failure to raise the U.S. federal debt ceiling ... would lead to a massive fiscal contraction and a financial crisis, although it would not necessarily mean a debt default," economist Nigel Gault concludes in an analysis for IHS Global Insight, a forecasting and consulting firm in Lexington, Mass. "The spending contraction, if sustained, would send the economy back into recession."

Mr. Gault explains the problem this way. Currently, federal revenues fall far short of spending. If Congress doesn't give the Treasury authority to borrow, beyond its current $14.3 trillion limit, there would be an immediate cut of 40 to 45 percent in government spending.

That cutback would equal about $1.5 trillion at an annual rate, or 10 percent of America's gross domestic product. So a recession, or decline in GDP, is not far-fetched if such an impasse were to persist.

Having no deal in place "would no doubt have a very adverse effect very quickly on the recovery. I'm quite certain of that," Federal Reserve Chairman Ben Bernanke said recently.

Meanwhile, debt-rating agencies have warned that America's credit score is already coming under scrutiny.

"Interest rates would be expected to rise – but by how much is far from clear," Mr. Gault said in his assessment.

In a no-deal scenario, the government would have incoming tax revenue that far exceeds the interest payments due (about $30 billion per month) on outstanding debt. So, in theory, the Treasury could try to prioritize payments so that credit markets are reassured that bond interest payments are not at risk.

Rep. Michele Bachmann of Minnesota, who is seeking the Republican presidential nomination, is among a band of conservative lawmakers who argue that such dire warnings are overblown. She is sponsoring a bill designed to ensure that the US would pay creditors and military salaries in the event that the debt ceiling is not raised.

She accused President Obama of using “scare tactics" over the debt limit. "He wants us to believe that if we do not raise the debt ceiling by up to $2.5 trillion, we will default on our debt. This is simply not true," she said in a July 13 statement. "We cannot afford a blow to the reputation of the full faith and credit of the United States."

Some outside budget analysts say the Obama administration could ensure that Social Security checks are paid, despite a recent statement by the president implying that those payments would be vulnerable.

At the same time, some finance experts say an effort to prioritize the most important spending (such as debt payments) would damage America's reputation. Investors would witness a chaotic situation in which the government was reneging or delaying payment on commitments.

"Handling all payments for important and popular programs ... will quickly become impossible," budget analysts at the Bipartisan Policy Center write in an analysis of the no-deal scenario.

That is, when you add up the interest payments, Social Security, Medicare, Medicaid, defense operations, active-duty military pay, and unemployment insurance, the costs in August will outweigh incoming funds for that month. Moreover, there would be nothing left for huge areas of the government including federal courts, the FBI, food stamps, Pell grants, highway projects, tax refund checks, or federal employee pay.

That's based on a projection of about $172 billion in revenue flowing in during August and some $307 billion in planned spending.

The Treasury has no precedent for making such decisions to put some programs above others in priority. Past impasses have not come to the point where the Treasury is in such a tight spot. In a 1995 and 1996 government "shutdown," for example, only a mild disruption of government services occurred.

For now, the so-called armageddon scenario is hypothetical. Investors have been banking on the likelihood that a deal will be reached, though worried could rise as that August deadline ticks closer.

So far, efforts to reach a deal on the debt ceiling have been faltering amid a rift between Republicans (arguing for big cuts to federal spending) and Democrats (who favor a tax-revenue boost alongside spending cuts).