by Alex M. Parker

June 13, 2011

Blond holders may be placing too much faith in Congress

Politicians in Washington may be playing a game of chicken with the possibility of a U.S. default, but one of the most important spectators -- the bond market -- hasn't noticed yet.

The latest round -- a vote to raise the $14.3 trillion debt ceiling which failed by an overwhelming margin -- came after the markets had closed. Not that it mattered, since bond investors have shown little concern yet about the possibility of a U.S. government default. Unlike in Europe, where markets have see-sawed over ongoing negotiations to solve Greece's debt crisis. "(Lawmakers) are not going to compromise until they get down to the last few hours," says Barry Bosworth, a former economic adviser to President Carter and a senior fellow with the Brookings Institution. "They really can't back down right now, until there's some crisis that they're responding to." With most investors more worried about the situation in Europe and now signs of a slowing economy, so far the fight over the debt ceiling has barely made ripples in the global markets.

But the closer Congress gets to August 2, when Treasury Secretary Timothy Geithner says he wouldn't be able to avoid going above the debt ceiling, then the likelier investors will begin to dump their U.S. bonds on fears that a default might be possible. "I think investors will get serious if we're still sitting here in August," said Alvin Felzenberg, a professor of international relations at George Washington University and aU.S. News contributor.

The recent 97-318 vote against raising the debt ceiling was the latest maneuver in the continuing fight over government spending. Republicans have said they won't raise the limit, currently set at $14.3 trillion, unless it is paired with legislation to slash the deficit and rein in government spending.

Vice President Joe Biden has been meeting with representatives from both parties, including House Majority Leader Eric Cantor and Senate Finance Committee Chairman Max Baucus, a Montana Democrat, to hammer out a deal. Although both sides say they've made progress in the discussions, no details have been revealed about any common ground they've reached.

As with the European debt crises, a crisis over the debt ceiling is a contest between what will yield first -- economic reality, or the political reality that seems to stand in the way of serious deficit reduction. Both realities can be stubborn.

"Even in the case of Europe, the crisis has gotten pretty severe, and some of these European countries are going to default," Bosworth says. "But do they in fact do what they have to do? In many casess, no, because there's still a domestic political problem."

In America, the political stalemate isn't semantic or technical, but is rooted in drastically different views of the role for the federal government. Republicans have said that they won't sign onto a deal that includes tax increase -- whether through raising tax rates or by eliminating tax loopholes -- whereas Democrats aren't likely to agree to much in spending cuts if it isn't paired with tax hikes.

America's situation is unique because of the debt ceiling, a statutory relic from the days when government borrowing was rare. Were it not for the legal requirement to raise the ceiling, America's debt situation wouldn't be an immediate concern for investors. While some bond-holders have had doubts about America's long-term fiscal situation, the U.S. bond market remains strong, with the federal government enjoying historically low borrowing rates. But at some point investors will begin to worry that even the fear of a possible default could hike interest rates and send the global markets into a panic. "I think the bond markets are way too optimistic, that this will somehow all play itself out," Bosworth said. "But as some point, this is likely to become much more serious."


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