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First a shutdown, then a debt limit fight. Could that ruin the economy?

Washington's logjam over the government shutdown, and its wrangling over raising the national debt limit, have already slowed economic growth, many economists say. But threat of a debt default is grave enough to coax lawmakers to resolve differences, they hope.

By , Staff writer

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    President Obama said during a Sept. 27 press conference that failure to raise the debt limit would effectively shutter the economy.
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Picture the following chain of events that could play out as part of the fiscal showdown now engulfing Congress.

The stock market falls by 20 percent or more. The confidence of consumers and businesses takes a severe dive. The risk of recession rears its head. Credit-rating firms downgrade the safety ranking of US Treasury debt. Government borrowing costs jump permanently. And all this trouble in the United States deals a blow to the rest of the world economy, too.

That's how economists paint the potential effects if Congress fails to agree on raising the nation's official debt limit – the amount the US Treasury is allowed to borrow.

Recommended: What does the federal government do with your money? Take our taxes quiz.

Why all the dire implications?

In essence, it's because in an era of perennial federal deficits, the ability to borrow is ultimately synonymous with maintaining confidence in the US government and its currency, the dollar. A debt default by the giant economy whose bonds have long defined the phrase "risk-free asset" could throw world financial markets into chaos.

This scenario, while viewed by many as unlikely, has emerged as within the realm of possibility as Republicans and Democrats vie for leverage over the nation's budgetary future.

One sign of worry is that lawmakers allowed a government "shutdown" to occur as of Oct. 1 – in good measure because many Republicans want to prevent President Obama's health-care reform law from taking full effect next year. It's not that all federal funds stopped flowing (the shutdown hasn't affected Social Security checks, for example), but pretty much any federal activity not deemed essential ground to a halt because lawmakers hadn't authorized spending for the new fiscal year.

All this comes at what is already a challenging moment for the economy: The pace of growth is weak, the Federal Reserve may soon dial back its special stimulus efforts, and the law dubbed "Obamacare" is by some accounts creating its own tremors of uncertainty for consumers and employers.

"The implications would be very severe" if the debt limit isn't raised, says David Berson, chief economist at Nationwide Insurance in Columbus, Ohio. He calls it "a very, very low probability event."

Mostly, policy analysts and economists predict that the very dangers outlined above will be enough to coax politicians toward legislation that raises the debt limit. But even what one might call a "business as usual" outcome, with some last-minute maneuvering that averts a debt-ceiling calamity, carries some economic costs.

Watching politicians step toward the brink of an abyss is unsettling to investors around the world. US stock prices traded steadily downward, for example, during the days leading up to the partial government shutdown.

More broadly, perennial gridlock over taxes and spending creates uncertainty for businesses and consumers. Economists say it's hard to tally its precise effect, but they agree it's negative, and some argue it's substantial in scale.

"If not for the logjam in Washington the economy would now be much closer to full employment," economist Mark Zandi of Moody's Analytics told a recent congressional hearing. He cites an index of "political uncertainty" that has remained elevated since 2008, and especially since the passage of Obamacare and the partisan fiscal battles that followed. Mr. Zandi estimates that heightened uncertainty since 2008 has cost the economy 1.1 million jobs and has boosted the unemployment rate, currently 7.3 percent, by 0.7 percent.

This political impasse is different from the one back in 2011 that was patched over in an 11th-hour agreement.

Once again, Republicans who control the House of Representatives are using a fiscal deadline – in this case the need to fund the government for a new fiscal year and the need to raise the debt limit – as a moment to seek leverage against Democrats on legislative priorities.

Little support for 'defunding' Obamacare

But this time, the dispute didn't originate with a clash over the level of federal spending, or a bid to cut a "grand bargain" designed to stabilize federal finances for a generation to come. Instead, the big item for Republicans was opposition to a single Obama initiative, the 2010 Affordable Care Act (ACA), which this month is at a pivotal point in its implementation.

The president wants Obamacare to go into effect. Republicans don't, and their tea party wing has been viewing fiscal votes as a last-ditch opportunity to stop the ACA in its tracks, or perhaps at least to scuttle portions of it.

Mr. Obama appears to hold the high ground politically. The ACA is the law of the land, and although the public isn't enamored of the law, Americans don't support the Republican goal of "defunding" it, according to a Christian Science Monitor/TIPP survey.

Obama also has the bully pulpit and has used it to frame his case that basic congressional responsibilities such as funding the government and servicing the debt shouldn't be held hostage to politics.

"One faction of one party, in one house of Congress, in one branch of government doesn't get to shut down the entire government just to refight the results of an election," he said on Sept. 30. "Congress needs to keep our government open, needs to pay our bills on time, and never, ever threaten the full faith and credit of the United States of America."

Many political analysts, including some on the conservative end of the spectrum, agree with Obama's premise that the 2012 election was the nation's real opportunity to reconsider the health-care law.

But Republicans can also point to polls showing the public is on their side. A late September Bloomberg poll found 61 percent of Americans saying it's "right to require spending cuts when the debt ceiling is raised even if it risks default." Many Republicans say that view syncs with their efforts to use the debt-ceiling issue as a venue for pursuing fiscal reforms as well as for taking jabs at Obamacare.

Markets: Above all, don't default

So how will all this wrangling end?

Quite possibly, Republicans will conclude that the public will put most of the blame on them for the economic effects of any prolonged government shutdown or failure to raise the cap on federal borrowing. Already, surveys including the Monitor/TIPP poll show Republicans scoring the worst on leadership, heading into the shutdown.

As they seek a face-saving way forward, they might agree to a bargain that deals simultaneously with the need to fund the government and to raise the debt limit, while seeking to insert some additional items (perhaps on entitlement spending or tax reform) that they can point to as progress toward fiscal responsibility.

"I think it will be solved at the last minute," says Russell Price, senior economist at Ameriprise Financial in Minneapolis. "The critical thing for financial markets is that the United States does not default."

If that D-word, default, appears to loom close, stock market investors could start to send an increasingly blunt warning to Washington: "Could you stop messing with the economy already?"

The last time the US edged near default, when the debt ceiling came up for review in 2011, the stock market fell by nearly 20 percent even though Congress in the end allowed all the nation's bills to be paid without disruption.

The brinkmanship prompted Standard & Poor's to knock the US credit rating down a notch, driving a 600-point drop in the Dow Jones Industrial Average on a single day.

Economists say the procrastination in 2011 pushed up interest rates on Treasury borrowing. By one estimate, the resulting higher interest on those bonds will ultimately cost taxpayers about $19 billion. Consumer confidence also eroded during that standoff.

This time around, unlike then, the dissonance in Washington doesn't coincide with a flare-up of problems in the European economy. But forecasters widely agree that failure to raise the debt limit on time – the Treasury has said it will run out of financial running room around Oct. 17 – would have severe consequences.

One hint: When the US failed to promptly pay interest on some of its short-term debts for a brief time in 1979 – a kind of accidental but technical default – economists say it had lasting consequences for Treasury borrowing costs.

"That has cost us tens of billions of dollars, that one little mistake," Zandi said at the recent congressional hearing.

Failure to raise the cap would amount to an immediate and large cut in federal spending. At present, about $1 in every $5 spent by the government – whether to pay for programs or for interest on the national debt – is borrowed. Remove that leeway to borrow, and the spending cut would add up to more than $500 billion in a year.

Put another way, the cutback would equal about 4 percent of the nation's gross domestic product – much bigger than the so-called sequester spending cuts that took effect earlier this year. That would be a big shock for an economy that's been growing at a roughly 2 percent annual pace.

Effect would be felt globally

Investors worldwide, meanwhile, would change their view of US Treasury bonds, factoring in at least a degree of new doubt about the safety and reliability of a bedrock investment.

"The financial ramifications could be horrific, and not just in the US but globally," says Nariman Behravesh, chief economist of IHS Global Insight in Lexington, Mass.

As investors push up Treasury interest rates, the cost of borrowing would ripple upward worldwide, many forecasters say. That would dent economic growth, perhaps most notably in many emerging-market nations.

The so-called government shutdown is a smaller event, economically, but damaging nonetheless. In a conference call with reporters, Mr. Behravesh said the failure to fund discretionary programs knocks about 0.2 percentage points off the nation's GDP for each week the shutdown drags on.

If this seems a weather forecast with all storm clouds, remember: Forecasters generally say the risks at stake will help steer Congress away from the debt-limit cliff. And if lawmakers paper over their divisions, even in a less-than-perfect way, many economists expect private-sector job growth to gain some traction in the coming year.

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