Congress will probably push this to the brink, but they will raise the debt ceiling before the country defaults. The first rule for most politicians is to get re-elected, and the easiest way to guarantee losing in 2012 is to throw the country back into recession. If that happened, I believe the voters would correctly blame the leaders of Congress, and I think Congress knows that too. Therefore it won't happen. I'm not worried and neither are investors.On the other hand, Bruce Bartlett has been warning for months that, no, in fact the Republican congress was quite capable of failing to raise the debt limit:
It's never happened before. And I think many people in financial markets, and perhaps even in Washington, just assume away the possibility. They cannot conceive of the insanity of allowing the debt to default. But what I keep trying to explain to people is that these Tea Party people really are that crazy. And I'm just trying to get people to believe me.Watching the daily news flow, it increasingly seems that the Bartlett view is closer to the truth. A bipartisan group of senators is working on a compromise, but there seems to be no sense that House Republicans are likely to go for it. Kevin Drum suggests a hybrid view - that Republicans are crazy enough to trigger a default on government obligations, markets will go nuts once they realize this, and then Republicans will panic and fold (much like happened with the vote to approve the TARP plan during the 2008 financial crisis).
For now, I'm going to stick with my guess that we'll blow by the August 2nd deadline, markets will go nuts, and we'll end up with some kind of debt ceiling increase by August 7th. We'll see.That seems as good a guess as any. At any rate, it doesn't seem that an agreement acceptable to all the power-centers is particularly close and it's less than two weeks to August 2nd. So it seems likely that this will have to get significantly worse before it gets better. And that seems likely to leave some lasting stain on the financial reputation of the US, which in turn will lead to higher interest rates for a long time. It should leave a lasting stain: if the US is apt to elect a faction to power who are not responsible enough to ensure that the government meets all its obligations, then clearly the United States government is not a very reliable financial entity. Higher interest rates on US government debt will push up interest rates on corporate and household debt, which, of course, will tend to slow the economy further.
Speaking of things that seem likely to get worse before they get better, the latest news out of Europe seems little better. German leader Angela Merkel seems determined that any plan should involve a default on Greek bonds. That in turn will render Greek banks insolvent, which will render them unable to operate without extensive help from the ECB, which it is so far not agreeing to provide. Furthermore, if Greek bonds default in some manner, that can do nothing but increase the cost of borrowing for all other weak members of the European periphery.
At heart, the issue seems to be that the EU leadership has no plausible approach to the basic contradictions of the Eurozone. European monetary policy is being run in a way that is helpful to Germany, and completely unhelpful to the deeply depressed peripheral countries, and fiscal transfers on any scale seem to be out of the question. This means that the peripheral countries really have no reason to be in the Eurozone, and unless major structural changes are made, it seems likely that they will not be able to stay in the Eurozone. Meanwhile, at every stage, the leaders of key Eurozone countries are doing the absolute bare minimum required to stave off immediate disaster, while doing nothing to address the fundamental problem, which thus gets worse and worse. Assuming the leadership continues to operate in this way, it seems likely that we will continue to get more and more of the same sort of results.
On both sides of the Atlantic, these issues seem to have considerable potential to worsen to the point that they affect the real economy. If so, the oil price spike of 2010/2011 will be over, and resource issues will continue their retreat to the back of the business section of the newspaper. Only for a little while, however. The inexorable motorization of the developing world will continue, lower oil prices will cause delays in drilling and new supply projects, and the conditions for the next price spike will be put in place. And meanwhile, progress on converting away from oil will continue to move at a glacial pace.