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Busch: The Debt Ceiling Train Wreck

The United States is barreling down the track towards the debt ceiling of $14.3 trillion by mid-May according to the U.S. Treasury Department.

Recently, the Obama administration and Congress were able to compromise on a 2011 federal budget that funded the government for the rest of the fiscal year and avoided a government shutdown.

The debt ceiling problem is more complex and may not present an environment for compromise unless all the parties understand what’s at stake.

This is not a simple defunding of the US government where services like bank supervision or environmental enforcement are not provided. This is a situation where the U.S. government has to fund itself and the debt servicing (interest and principal) for all the global U.S. Treasury security holders.

The ability (and consistency) of the United States government to service its debt is the central reason the debt rating agencies have maintained a AAA rating on our debt. It has allowed the U.S. government to borrow at lower interest rates than if the debt was rated lower and therefore allowed the government to borrow more.

The United States also has been able to borrow at favorable interest rates due to the fact that it can borrow in its own currency and that the US dollar is the world’s major reserve currency. This means that US Treasury isn’t forced to offer higher interest rates to attract the capital that it needs.

If the United States chooses not to raise the debt ceiling, the US Treasury can’t issue new debt and will eventually default on its debt obligations. While it’s difficult to envision a situation where Congress never approves a hike, the financial conditions of the country are so poor that even the threat of no hike is causing concern in the financial markets and in the international community.

The pernicious aspect of this is that as a hike is delayed or debated, the costs of servicing the debt go up and investors demand a risk premium to buy the debt. Greece, Ireland and Portugal offer compelling examples of this force at work when investors became uncertain over the ability of these governments to meet their obligations.

A potential Republican strategy for a series of short term debt hikes where the US Treasury is only allowed to issue enough debt to cover two to three weeks of obligations would create uncertainty and anxiety for bond holders.

While the goal would be to extract more spending cuts and perhaps entitlement cuts, the risk is not likely worth the reward. As Will Rodgers once said, “It takes a lifetime to build a good reputation, but you can lose it in a minute.”

The corollary is you lose is even faster if you don’t pay your bills on time. Although most in the market believe the US will not default, a rolling debt hike strategy that elongates the process for several months (Fourth of July?) will bring reputational risk and warnings, if not a downgrade, by the ratings agencies.

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  • Currently, the discussion out of the Republican controlled House of Representatives revolves around cutting additional spending and controls on future spending to approve a debt hike.

    Although both President Obama and House Republicans (led by Budget chairman Paul Ryan) have put forward competing deficit reduction plans, this will likely be debated through 2012 presidential elections and not be resolved via the debate over the debt hike.

    A credible structural reform plan to address the long term deficits and the subsequent debt must occur if the nation is to grow and create jobs.

    The accumulation of $14.3 trillion in debt did not occur with the present Congress. It represents past politicians making obligations that the nation must currently find a way to fund. It is not new spending.

    Both Congress and the President must realize that by not approving a hike in the debt ceiling they will de facto be increasing government spending as interest rates rise over the risk of default.

    Unless a solution is quickly found to raise the ceiling, they will both be seen as the conductors of the debt trains that collided and the casualties will be the US dollar, US Treasury securities and the US government’s credibility.

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    Andrew B. BuschDirector, Global Currency and Public Policy Strategist at BMO Capital Markets, a recognized expert on the world financial markets and how these markets are impacted by political events, and a frequent CNBC contributor. You can comment on his piece and reach him hereand you can follow him on Twitter at http://twitter.com/abusch.