How Would Wall Street React to U.S. Default?

Markets could keep from plunging as Obama and Republicans negotiate, but things won't be pretty if America can't pay its bills

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As Mondays on Wall Street go, this one wasn't black, or even charcoal. It was a sort of dishwater gray - murky, but by no means scary. The Dow and the S&P closed down more than a half percentage point at the end of trading, delivering relatively light losses for a day when many analysts had worried Washington's debt-ceiling standoff would finally draw a harsh rebuke from markets.

So, congratulations, lawmakers. You went one more day without tanking the economy. But don't get the wrong idea. You're about to run out of time, if not with the markets, than with American consumers.

The debt-limit debate, if left unresolved, could still bludgeon the U.S. recovery in two main ways. A market reaction is the first: The moment bond traders, or stock traders, become convinced lawmakers that aren't going to raise the debt limit by August 2, they could trigger a sell-off on par with the plunge that followed the first failed vote on the Troubled Asset Relief Program in the fall of 2008. Sure enough, analyst firm MKM Partners warned clients on Monday, "The current debt-ceiling impasse has the same feel to it that the TARP vote did back in 2008."

It's tough to say when such a market reaction might happen. After all, the best argument for moving quickly to curb mounting U.S. deficits - as opposed to waiting a year or so for the economy to speed up, because little evidence indicates that debt levels are stunting growth or displacing investment right now -- has always been that markets are vicious and unpredictable.

Any member of Congress who has warned constituents about sudden, skyrocketing borrowing costs born of fear about total federal debt must recognize that the same logic applies to a possible debt default, but with a dramatically shorter timetable.

But even if markets somehow hold faith in Washington's ability to pull out a debt-limit deal for another week, massive economic pain still waits on the other side of August 2. That's because, market plunge or no, with or without a downgrade from the ratings agencies, the federal government is going to run out of money to pay all of its bills on time unless the debt ceiling is lifted. In fact, the money coming into the Treasury will only suffice to pay about 60 percent of the nation's obligations.

What that means is that a lot of people aren't going to get paid - some combination of people including creditors, federal employees, contractors, soldiers, and/or some Medicare and Social Security beneficiaries. When those checks don't go out, the effects will ripple through the economy. Hundreds of thousands of Americans are likely to lose their jobs, and even if Washington gets its act together quickly, the analyst firm Macroeconomic Advisers said last week, the fallout will linger through 2012.

So don't see Dishwater Monday as anything less than what it is: a reprieve, and one more day to avoid catastrophe.

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