The Debt-Ceiling War: Wall Street Could Be a Casualty

When the new Congress meets for the first time this week, debt and government spending will sit firmly at the top of its agenda. Unlike past debates, this one could have a chilling effect on Wall Street -- as worried traders wonder if the U.S. could end up on the same chaotic economic path taken by Greece or Spain.

No one really thinks the U.S. can't pay its bills anymore. But a threat by some Republicans to vote against raising the debt ceiling -- currently at around $14 trillion -- could cause major headaches for investors in the near future. The government is expected to hit that ceiling at some point in the next few months, possibly as early as March.

Playing a "Game of Chicken"

"Wall Street owns the government bonds and the debt of Fannie Mae and Freddie Mac, all of which are going to be plunging in value in the event a debt default becomes a reasonable possibility," says Dean Baker, co-director of the Washington D.C.-based Center for Economic and Policy Research. "The idea that these assets might be worth less than 100 cents on the dollar would be a huge hit to their bottom lines."

Alan Brill, a research fellow at the American Enterprise Institute in Washington, agrees that at some point -- even though the markets know U.S. debt will eventually get issued -- investors are going to become more wary. "For the guys who live off short-term paper, there is going to be a little more of a risk premium there," he says.

Baker acknowledged the Republicans appear to be engaged in a "game of chicken" -- in which the Obama administration and the Tea Party wing of the Republicans each wait to see who will flinch first -- and then agree to concessions to get the debt ceiling raised.

Showdown in the Senate

Speaking on the Sunday talk shows, Austan Goolsbee, chairman of the White House Council of Economic Advisers, warned the debt ceiling was not a game to be played with. "If we hit that debt ceiling, that's essentially defaulting on our obligations, which is totally unprecedented in our history," he said. "The impact on the economy would be catastrophic."

Goolsbee's warning followed an announcement by Sen. Jim DeMint (R-S.C.) that he was planning a confrontation in the Senate to force Obama to cut spending. "We need to have a showdown at this point that we are not going to increase our debt ceiling any more," said the senator, who has a lot of support from the Tea Party faction and even some mainstream Republicans.

But analysts are divided about whether, politics aside, such a forced cut would be a good thing for the overall economy.

Brill is in the camp that says such a cut is necessary. "We want the market to be of the opinion that we are on a sustainable path," he says. "The question is: Is there some spending now that could be so good for the economy that it would outweigh the consequences of having an unsustainable path? I think the answer is no."

No Consensus on Forced Cuts

Brill says the administration should cancel all funding in the 2009 stimulus package that remains unspent, especially for projects -- like the high-speed rail -- that could end up costing much more over the long term.

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But Baker vehemently disagrees, saying a forced cut now would seriously undermine the nascent recovery. "No doubt it's going to lead to a deeper recession," he says. "Right now the public sector is supporting the economy."

The argument that public sector spending is crowding out private sector growth isn't true, Baker claims. He believes the Fed should substantially expand its balance sheet and buy up much of the deficit, just as it did recently with other government bonds in a program called quantitative easing. By buying $4 trillion to $5 trillion in debt, he says, the government would effectively be paying itself the interest owed -- and thus avoid hurting the budget.

He points to Japan, where that nation's central bank holds an amount of government debt equal to the country's entire GDP with no apparent adverse consequences on interest rates.

As the new Congress gets deeper into the debt-ceiling debate, Wall Street will certainly be paying close attention.