US debt default serious though manageable, but not loss of AAA rating

AS WASHINGTON continues to debate a debt deal, the Obama administration has been preparing the country for the worst, with officials essentially saying the sky is about to fall. But so far, oddly enough, nothing has happened. Despite warnings that a deal would need to be brokered by Sunday night before the Asian markets opened, stocks merely stumbled on Monday the type of weakness usually associated with soft corporate earnings instead of an economic apocalypse.

Wall Street's blase response presents a serious challenge for the administration. The government has been ringing the alarm bells of an impending catastrophe to add urgency to its efforts to get the Republicans to hash out a compromise.

While the sky indeed may fall if a deal isn't reached, the fact that the market has been calm has served only to deepen the resistance to a deal. People who perhaps should be worried don't seem to be and, worse, appear to have stopped listening to the warnings.

How did it come to this?

The administration may have made a strategic mistake in warning too soon that the market would react negatively. It ultimately undercuts the government's negotiating position because the doomsday scenario has not played out, even though the deadline is fast approaching.

"They have lost all credibility," said Neil Barofsky, the former special inspector-general for the Troubled Asset Relief Program. "It's so typical of the way Treasury and the Fed treat everything it is always to warn that Armageddon is coming."

Treasury Secretary Timothy Geithner is among those who may have miscalculated.

He has consistently held out August 2 as the cutoff date for lawmakers to reach a compromise. After that, Geithner has said the government might not be able to continue sending out Social Security cheques or Medicare payments. "On August 2, we're left running on fumes," he told the CBS program Face the Nation.

He told me in May that he was expecting to reach a deal by mid-July, way ahead of the final deadline. "Why would you want to experiment? In July, you'd want this done."

But increasingly the market seems to believe it was a false deadline. Some economists have said the government would have enough cash on hand to continue making payments for several days at least. The administration could also decide how to prioritise payments. The government, for instance, could opt to pay interest on Treasuries and put off other bills.

In other words, the US has some wriggle room.

"The August 2 deadline is not as hard as indicated by Secretary Geithner," said Mohamed El-Erian, the chief executive of PIMCO, the large bond manager.

It doesn't help the government's case that investors believe the debate over the debt ceiling amounts to political posturing. Wall Street is counting on lawmakers to work out a deal, albeit at the last minute a big reason the markets remain sanguine.

"The markets believe the political parties will reach a compromise agreement to avert a default," El-Erian said, especially considering that they may have a bit more time on the doomsday clock.

Investors have good reason to ignore the drama. In years past, politicians have rubber-stamped an increase in the debt ceiling with little discussion or dissent. Since 1962, Congress has voted to increase the limit 74 times, according to the Congressional Research Service, a division of the Library of Congress. It happened 17 times under president Ronald Reagan and four times during the Clinton administration.

But investors may have been lulled into a false sense of security and, as a result, they may have missed the bigger picture.

Whether lawmakers reach an agreement about the debt ceiling may be beside the point. Republicans and Democrats are likely to compromise at some eventual date. The question is how rating agencies will view the country's creditworthiness, even if a deal is reached.

To some extent, that's why lawmakers are wrangling over whether to pursue a stop-gap measure for the next couple of months versus a long-term plan. Standard & Poor's threatened that it would cut the US's rating if lawmakers didn't come up with a "credible" solution.

"What I think is under appreciated until now is a possible outcome whereby the debt ceiling is increased, debt default is avoided, but one of the rating agencies feels compelled to downgrade America's AAA rating because of insufficient agreement on medium-term fiscal reform," El-Erian said.

If the country were to lose its vaunted rating, the federal government, companies, homeowners and innumerable others would see their costs skyrocket a situation that would certainly send the markets into a downward spiral.