Drama or crisis?

28 July 2011 Last updated at 10:44 GMT By Damian Kahya Business reporter, BBC News Some Republicans are firmly against raising the debt ceiling As worries over debts move from Europe to the US, the markets have reacted with only mild panic.

Economic problems in the US could be far more serious for the world economy than anything that could happen in Greece.

But some economists have suggested that an essentially political drama is being mistaken for an economic crisis.

The US government needs the permission of Congress to raise the ceiling on the amount of money it can borrow.

If Congress doesn't grant it - currently the deadline is 2 August - the government will hit the limit and may have difficulties in paying its bills.

But there is a wider economic problem behind the stalemate.

The US - like Greece - is spending far more than it earns through taxes.

The annual budget deficit has reached $1.5tn (£920bn) this year - just over 10% of GDP - and the country has amassed a national debt of around $14.3tn.

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The interests of voters and the interests of the markets are completely at odds”

End Quote Dr Pippa Malmgren Principalis Asset Management President Barack Obama and the Republican controlled House of Representatives both agree the US needs to borrow less in the future - they just disagree on how.

It's that argument which is delaying progress on lifting the current borrowing limit.

As a result, ratings agencies have suggested that they may downgrade US debt from its benchmark top-rated AAA status - unless the two sides agree on radical action to lift the limit and cut the deficit.

Default

The immediate worry for investors is that, if no deal is agreed by the 2 August, the US may find itself at risk of a so called technical default.

"The interests of voters and the interests of the markets are completely at odds," says Dr Pippa Malmgren from Principalis Asset Management.

Some members of Congress were elected promising not to allow the government to run a deficit.

"The market keeps being surprised when it shouldn't be. You will win votes if you shut the government down," she says.

President Clinton shut down some government services in 1995 after parties failed to agree a budget

But a failure to reach a deal by the deadline may not provoke panic.

"The 2 August deadline is not an absolute deadline, because tax revenues are pretty good so far," says James Knightley from ING.

Potential impact

If it does run out of money the government may stop paying wages and social security checks - a so-called 'shut down'.

Government last shut down under Bill Clinton in 1995 when non-essential government services stopped after similar failed negotiations over the budget.

That would hurt the fragile economic recovery - but many economists find it hard to believe the US would ever default and fail to pay its debts.

"I think the risk of that is almost zero," says Josh Feinman, global chief economist for DB Advisors.

"They'll keep paying the bond holders but they'll stop paying someone else." he added.

Not everyone agrees with Mr Feinman though.

The US needs to re-finance $1.7tn, or 12% of its total debt this year - that would be hard to do if it can't borrow fresh funds.

Fidelity, one of the largest private sector holders of US bonds, say they have been preparing for a possible default.

"We have re-positioned our portfolios to respond to [the threat of default] and that means we have raised our liquidity [cash] and adjusted our portfolio maturities past the early part of August," says Robert Brown, head of Fidelity's money-market business.

That means funds - which lend money to banks and businesses - are already holding more cash to prepare for a possible default.

This limits the amount they can invest - potentially driving up the cost of lending to businesses.

The cost will stay high until investors believe the crisis is solved on a long term basis.

With so much at stake some warn that, unless it is resolved soon, the political stand-off may undermine wider business confidence.

"We've got a melodrama here and we're going to have a panic for no good reason," warns Professor Peter Morici from the University of Maryland.

"If they do something at the eleventh hour they might not avoid panic. Companies are starting to hoard cash and delay hiring, that is the beginning of a crisis."

The economy could slow as companies panic over the uncertainties created by seemingly endless negotiations in Washington.

Downgrade

Even if the borrowing limit is raised, the US may have its top AAA credit rating downgraded.

Ratings agency Standard and Poor's has cut its outlook on the US's credit rating to negative.

Economists say agencies want a comprehensive deal to limit the US deficit over the long term.

"Agencies have said if we don't get the debt ceiling raised soon, coupled with an agreement in both houses of Congress to stop the debt ballooning, then we are going to downgrade the US," says Phillip Shaw from Investec.

Lowering the credit rating may make it harder for the government and companies to borrow money in the long term.

"You might see some impact outside of treasuries," warns Mr Feinman.

Markets have so far failed to panic over debt talks

US debt would be less safe, so investors holding it would have less freedom to lend to other, riskier, companies.

"If you downgrade the US then they might have to sell some lower-rated stuff in order to keep the average credit quality."

But he doesn't think a downgrade makes any sense.

The US, he says, is not like Greece - it controls its own currency and can print as much as it likes to pay back debts.

"A credit rating is based on the chances [lenders] are going to get paid back. When you control your own monetary policy what does a rating even mean?" argues Mr Feinman.

Figures collated by ING show that 45% of US debt is held by the US government - which is unlikely to be unduly perturbed by a downgrade.

Even money-market funds such as Fidelity would not have to sell their debt, as US law makes government debt exempt from rules about diversification of risk.

Over the long term though the US may find it very hard to recover it's credit rating - should it need to.

"In my 16 years at Fidelity and at other firms, I've never seen an upgrade to AAA. We are the bellwether for safety and there are a lot of advantages that go with that," says Mr Brown.

Distraction

Some argue the episode is a distraction.

"The slowdown we are seeing in emerging and developed markets, together with the ongoing European crisis, is foremost in my thinking," says Rick Patel, portfolio manager at Fidelity International in the UK.

He sees the current uncertainty as investment opportunity.

"I've been investing in US treasuries largely because of the weakening growth outlook [in the US] which leads me to think treasuries are the way to go."

For others, the focus will soon return to Europe, where governments can't simply print money to get out of debt.

"Once the US story is complete and that is past we are going to revert to the eurozone story again," says Mr Knightley.

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