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Debt ceiling: With debate on hold, where is US economy headed now?

With the debt ceiling's threat no longer imminent, the US economy appears to be stuck in neutral, waiting to be pushed forward or back. Here are head winds and tail winds competing for influence.

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"If someone had any exposure to stocks by being up 16 percent, it helped with their feeling of well-being and got us one step closer to full recovery," says Sam Stovall, chief equity strategist at S&P Capital IQ in New York.

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Could it happen again in 2013?

Through mid-January, the S&P was up another 3 percent, a gain of $408 billion in value.

If Congress and the White House were to reach an agreement on the debt ceiling, the economy could grow closer to 3 percent instead of 2 percent, says LPL Financial's Canally.

"Then we get a 20 percent gain in the market," he says. "If they can't agree, and it lingers on, we go into a bear market and a mild recession."


There's that 'R' word again

In a warning to Congress about the debt-ceiling issue Jan. 14, Mr. Obama said a default on debt payments could "slow down our growth" and "might tip us into recession."

Even Federal Reserve Chairman Ben Bernanke warned that a downturn is not out of the question. At the University of Michigan the same day, he described the US economy as being in a "relatively fragile recovery" and cautioned that "we want to avoid taking fiscal actions that will push the economy back into recession because that was one of the risks that the fiscal cliff posed."

So what would trigger a recession? Economist Robert Brusca of Fact and Opinion Economics offers at least two scenarios:

The US defaults on its debt

In the first and most dramatic possibility, the US government defaults on its debts and basically is declared bankrupt.

"This becomes a big financial markets issue because some firms must hold highly rated bonds or some can't hold bonds of entities in bankruptcy," says Mr. Brusca.

Under this sequence of events, as insurance companies and others race to dump bonds, yields on US Treasury securities soar. Borrowers around the world would have to pay more for loans – if they could even get them. A recession would take place quickly.

Gradual government shutdown

The second scenario, Brusca says, would be what he terms "a slow melt." The cash-strapped US government is forced to prioritize payments on the basis of what revenue it has coming in. For example, the US Treasury might make interest payments on its debt but would not pay air-traffic controllers, public parks employees, and food inspectors.

"In this game of chicken, the president shuts down the most public agencies so the public can see and feel the effects," says Brusca. "Can you imagine what happens if people can't fly?"

This would not be the first time the government has shut down over the debt ceiling. At the end of 1995, President Bill Clinton and House Speaker Newt Gingrich clashed over spending cuts and raising the debt ceiling. When Congress refused to raise the ceiling, Mr. Clinton started furloughing government workers. "The Republicans got a black eye," recalls Brusca.

The stock and bond markets took hits as well, but the economy avoided a recession. "The economy was a lot stronger then," he says.


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