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Washington's Debt Ceiling Showdown Could Be Big Trouble for Investors

If Congress doesn't reach an agreement by the August 2 deadline, the fallout could be worse than Wall Street anticipates.

The annual Morningstar mutual fund conference in Chicago in mid June brought together fund managers, investment advisers and other financial pros from around the country. (See Editor Janet Bodnar's FUND WATCH: What I learned at the Morningstar Conference.) What was most surprising to me -- and most troubling -- was what they didn’t talk about. I heard virtually no concern that Congress might fail to reach agreement on raising the debt ceiling by August 2, the date Treasury Secretary Timothy Geithner says the U.S. will otherwise default.

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Here’s the problem: Wall Street and Washington have never been able to communicate. Wall Street rightly anticipates a high-stakes game of chicken -- with Republicans angling for the biggest spending cuts they can get, and Democrats arguing for smaller cuts and higher taxes on the wealthy. When the deadline is reached, though, Wall Street fully expects both sides to behave rationally, take the best deal they can get and approve an increase in the debt limit by August 2. President Obama’s collegial golf outing with House Speaker John Boehner (R-OH) on June 18 was intended to lay out the contours of such an eventual deal.

I’m still worried, however. It’s heartening to see Vice President Joe Biden negotiating with House Majority Leader Eric Cantor (R-VA) over what to cut. But several bipartisan panels have already come up with good plans to resolve the debt crisis -- and they’ve gone nowhere in Congress. Failure to reach a deal could be far more catastrophic than people seem to realize. (Senior Editor Jeffrey R. Kosnett is less concerned about the looming debt ceiling deadline; for his take on the situation, see CASH IN HAND: Time to Sell Treasuries.)

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Failure to raise the debt ceiling could touch off a mini-financial panic in August and September, perhaps throwing the fragile economy back into recession. That gives the White House plenty of incentive to compromise.

On the Republican side, Boehner and Senate Minority Leader Mitch McConnell want the debt ceiling raised for the same reasons Obama does -- and because they don’t want to get blamed for screwing up the economy. The question is whether Boehner can coax the Tea Party Republicans into accepting a half-a-loaf package that doesn’t make the huge spending cuts its members want.

The Tea Party is right about the nation’s long-term debt. The path we’re on is quite simply unsustainable. Spending on Medicare and Medicaid, if unrestrained, will gobble up more money than we can ever afford to repay. The U.S. will end up like Greece.

But what’s vital right now is that the U.S. not default on its debt. We never have, and we never should. Federal Reserve Chairman Ben Bernanke says failing to raise the debt ceiling on time could cause “severe disruptions” in the markets. “We should avoid unnecessary actions or threats that risk shaking the confidence of investors in the ability and willingness of the U.S. government to pay its bills,” he says.

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Alas, many in Congress still don’t see it that way. Quite a few Republicans maintain that the important thing is to cut spending -- and that the global financial markets will forgive us a short-term default if that’s the price we have to pay to staunch the flow of red ink. What’s more, they say, Geithner can stop paying less-essential bills without defaulting on Treasury obligations. What’s the big deal?

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Given how strongly many Republicans feel about slashing spending, I worry that we’ll fail to increase the debt ceiling until days or weeks after the August 2 deadline. I fear that the only thing that will trigger a majority vote in Congress to raise the debt limit will be short-term market chaos.

I remember only too well September 2008, when Congress initially voted down Treasury Secretary Henry Paulson’s proposal that members appropriate up to $700 billion to bail out the banks. Only after Standard & Poor’s 500-stock index plunged 8.8% that day did Congress see the light.

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I also worry about the medium- and long-term effects such an event could have on the markets. After all, no matter whose budget plan Congress adopts, we’re going to be in hock to China and Japan to the tune of trillions of dollars for many years to come. The dollar’s status as the world’s reserve currency saves us a ton of money on interest payments.

What to do as an investor? I would never make wholesale moves based on potential short-term problems. But this could be a good time to take a few chips off the table, until the market recognizes the obstacles Congress is facing.

The talk in financial circles the last few years has been about black swans: unforeseeable events that have an enormous impact on financial markets. The odd thing about the debt-ceiling vote is that it has been utterly predictable for many, many months. Call it a white swan. But unless Congress acts, this white swan could cause as much havoc as any black one.

Steven T. Goldberg (bio) is an investment adviser in the Washington, D.C., area.

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