Debt Ceiling Standoff: Will the Financial Markets Force a Deal?

Republicans and Democrats are still deadlocked over the bill to raise the debt ceiling, and so far the negotiators appear intractable. Indeed, many lawmakers say they’re not worried about the prospect of the government running out of money if there’s no deal by Aug. 2. Some openly scoff at warnings that a U.S. default would have serious consequences.

The game of chicken over the debt ceiling bill has become an annual fixture, no matter which party controls Congress, but this time it’s proving more serious. The atmosphere is more partisan, and both sides are more entrenched than they’ve been in years. Barring some eleventh-hour bargain, the risk of a default has intensified.

There’s still one thing that could break the stalemate: turmoil in the financial markets. Right now, most investors still believe that lawmakers eventually will compromise and raise the debt limit in time to stave off default. If investors ever begin worrying that they were too optimistic, the markets could begin a free fall. Then watch lawmakers scramble.

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With financial markets still fragile and prone to quick reaction, the market frenzy could come abruptly. But even before government borrowing hit the current ceiling, there’d be some warning signs: Investors would begin selling off Treasury bonds; stock prices would fall; and the dollar’s value would gyrate.

Once Treasury hit the deadline and began deferring payment of bills, the markets would turn with a vengeance, and would likely overshoot before finally stabilizing. The consequences would be dizzying, and might well plunge the economy into another recession. The political impact also would be swift. Voters would be quick to blame those who brought on the default.

This wouldn’t be the first time that the markets forced the government to take action when it was about to do something irresponsible. In the early 1990s, worried investors—known then as bond market vigilantes—sent interest rates soaring over fears that the Clinton administration’s proposed new spending programs might exacerbate inflation.

When the president finally abandoned those spending plans, the markets eased up again. The Clintonites felt obliged to hew to the new religion they’d gotten and keep a lid on federal spending. The economy surged, and the president ended his second term with a prosperous economy—and a sizable budget surplus, to boot.

Just last week, investor concern over the debt crisis in Greece sent markets all over the world reeling. Prices of stocks, crude oil, commodities, and currencies plummeted everywhere, including the United States. If Greece’s flirtation with default can spark such turmoil, even the hint of a genuine U.S. default could easily wreak havoc.

To be sure, the current situation isn’t an exact replica of the bond vigilante days of the early 1990s. But there already have been hints of something similar in the works. Three major credit-rating agencies have threatened to downgrade the U.S. government’s credit status if Congress fails to increase the borrowing limit by early August.

And some large banks that had been buying U.S. Treasury securities as a hedge against market turbulence are reportedly preparing to reduce their holdings in August and instead will keep more cash on hand to use as collateral for transactions. (In April, private investors sold more Treasury bonds than they bought—for the first time in two years.)

Even if lawmakers finally move to raise the government’s legal borrowing limit before it is forced to stop paying anyone, playing with fire (as lawmakers are doing by holding the debt ceiling bill hostage) risks setting off a conflagration. And by diverting attention from serious budget issues, they’re making sure that any compromise will be meager.

The temporary—and superficial—spending cut agreement that lawmakers put together last spring under similar deadline pressure won them more brickbats than praise and did little more than kick the budget can down the road again, this time to the current debt ceiling bill. If the financial markets go into a frenzy, it won’t provide political cover.

As Federal Reserve Chairman Ben Bernanke put it last week, even a brief default on U.S. government debt “could cause severe disruptions in financial markets,” create “fundamental doubts about the creditworthiness of the United States,” and “damage the special role of the dollar and Treasury securities in global markets” for the long term.

What party wins in that kind of outcome?