Debt ceiling: Now what?

@CNNMoney July 23, 2011: 5:02 PM ET

NEW YORK (CNNMoney) -- It's very hard to see how this ends well.

On Friday, for the third time in a month, Republicans abandoned negotiations with the White House over how to reduce the country's medium and long-term debt in time to raise the nation's debt ceiling.

"It is a good thing that this political breakdown was announced on a Friday afternoon as it gives Washington two days to engage in crisis negotiations aimed at restoring some sense of political normalcy before markets open in Asia," said Mohamed El-Erian, CEO of Pimco, the world's largest bond management firm.

Normalcy? That may be a long way off. "It could be worse ... and probably will," said longtime budget expert and political observer Stan Collender. (Read: How it could hit Main Street)

This was an avoidable crisis: Treasury Secretary Tim Geithner put Congress on notice in January that the debt ceiling would need to be raised. Now, the country's credit rating is at risk of being downgraded for the first time.

Bernanke: Debt ceiling breach 'calamitous'

If lawmakers don't raise the federal government's legal borrowing limit by Aug. 2, Treasury has said that it won't be able to pay all the country's bills in full.

"A failure by politicians to reverse course would be very harmful to an already fragile U.S. economy," El-Erian said. "The potential consequences could well extend beyond the debt ceiling debate."

And, he added, "investors, especially outside the U.S., will be struck, if not stunned, by the increasingly bitter tone of U.S. political interactions."

On Saturday, Boehner told House Republicans in a conference call that he wanted to announce a solution to the impasse by Sunday afternoon before markets open in Asia, a GOP aide familiar with the call told CNN.

It remains to be seen how investors, who have so far mostly watched but not acted on the debt ceiling debate, respond to the latest breakdown.

But experts warn that a failure to raise the debt ceiling in time would -- if not immediately, then soon enough -- send shockwaves through the underpinnings of the financial system that could ripple out to individual investors and consumers.

The federal government would be forced to prioritize its payments. It would risk defaulting on its financial obligations. And if that happens, credit rating agencies would downgrade U.S. debt.

"Even if Washington did raise the debt ceiling after just a few harrowing days following a default ... we envisage that the economy could fall quickly back into recession," rating agency Standard & Poor's said this week.

Federal Reserve Chairman Ben Bernanke said the fallout could be "catastrophic" and "self defeating."

Markets and Money: Investors continue to assume that Congress will do the right thing and raise the ceiling by Aug. 2. If Congress dashes those expectations, no one can know exactly how the markets will react.

But most think they will react, and not well. And the longer the crisis drags on, the worse conditions will get.

Some bond experts expect that contrary to popular belief, Treasury rates won't rise but stocks may tank. In other words, there will be a move out of risk-based assets and a flight to safety in bonds.

So interest rates may stay low, but Americans' investments may get whacked. Or, Treasury yields could become volatile and start to climb as investors lose faith that lawmakers have the political will to be fiscally responsible.

That would push the cost of U.S. debt higher. And it could cause rates on consumer loans -- like mortgages and car loans -- to climb higher as well.

Federal Fallout: If the debt ceiling isn't raised, the federal government won't be able to pay 44% of its bills worth an estimated $134 billion, according to a Bipartisan Policy Center analysis.

On an annualized basis, it's the rough equivalent of cutting spending by $1.6 trillion -- which is more than all of so-called discretionary spending, including defense.

Why? It's basic math: The United States doesn't bring in enough revenue to pay all its bills -- with monthly deficits averaging $125 billion.

And Treasury won't be allowed to borrow new money to make up for the gap between revenue and spending.

Technically, it wouldn't be a "cut" in spending so much as a postponement. That's because the bills the Treasury Department puts off will have to be paid once the debt ceiling is raised.

But if government spending were to suddenly dry up even for a short while, it could send a ripple through the economy and slow growth.

U.S. Credit Rating: All three major credit rating agencies have warned in recent days that they are considering a downgrade of the nation's debt.

To date, the United States has enjoyed its AAA rating in part for having always stood behind its debt and paid its bills on time. As a result, U.S. Treasury bonds are considered the world's safe-haven investment.

Hold up! Still no deal to raise the debt ceiling

If the U.S. were to lose its AAA credit rating, foreign investors, who hold about half of all U.S. Treasuries, might demand higher interest rates in exchange for holding the debt.

And other major holders of U.S. debt, like pension funds, states and insurance companies, would be put in the awkward position of having to decide whether to take their money to other safe-haven investments.

For at least two of the rating agencies -- Moody's and S&P -- raising the debt ceiling is not enough. They also want to see lawmakers agree to substantial debt reduction.

Standard & Poor's has already said there is a a one-in-two chance it would downgrade the United States within 90 days.

--CNNMoney staff reporter Charles Riley and CNN's Brianna Keilar and Deirdre Walsh contributed to this report. To top of page

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