US economy; between devil and the deep sea….

The US economy is facing a crisis situation which, if not addressed by the end of this month, can blow up as a national catastrophe. As reported by The Christian Science Monitor, Washington’s self-imposed deadline to do something credible on the debt crisis before the Asian financial markets opened on Sunday passed in silence, marked only by camera crews vainly chasing rumors up and down the empty stairwells of the Capitol. American leaders will soon have to decide whether to pursue a serious deficit-reduction agreement among themselves before the 2012 elections. Standard & Poor’s, in April 2011, cut the outlook on the U.S.’s long-term credit rating from stable to negative for the first time since the bombing of Pearl Harbor. The biggest donor to Pakistan has to make its economic managers look a lot better than those who are currently managing Pakistan. The problem is simple and complex at the same time; the reason being that two major political stakeholder, Democrats and Republicans are not coming to a consensus solution. It is time for making hard choices and, contrary to Pakistani politicians, those in power in Washington DC are putting their second term at risk by proposing increased taxes as a measure to get out of the debt crisis. Those in opposition, the GOP, are not coming to terms because they cannot expose their hopes of a comeback to the risk of public displeasure. The hard choices will either way lead to unemployment and slow-down of economy.

The US has been faced with this catastrophic situation when it has to make enormous investments in national security and an overseas war being fought in Afghanistan. There will hardly be a choice to make fiscal space through cutting down the defense spending. Resultantly, other spending, mostly obligatory, will face the axe in the coming years which will hurt the common man and the taxpayers. Normally, cutting down government spending through austerity measures should be compensated by the private sector but there is no indication that the private sector will come forward in a big way. Employment will, therefore be the first casualty. The opposition is bent upon forcing the administration to cut federal spending and cap them and also strip the administration of the powers to raise taxes.

According to CNNMoney, “cut, cap and balance” is fast becoming the catchphrase of those who say they are serious about fiscal responsibility. The proposal, made by a big group of House Republicans, with 103 Republican members signaling their support for it, would:

— cut federal spending in the next fiscal year by $380 billion;

— cap spending at 18% of the size of the economy within five to six years from now; and

— amend the Constitution to require Congress to balance the budget every year and make it more difficult for lawmakers to raise taxes.

These conditions are a pre-requisite to supporting any debt limit increase. But President Barack Obama stands firm against Republican demands for deep spending cuts without any tax increases as the condition for raising the country’s borrowing limit and avoiding a debt default. With Washington gripped by a growing sense that it may be too late to avert a crisis, the president has said he will give the increasingly rancorous negotiations until the end of next week to reach agreement on the terms for raising the US’s $14.3 trillion debt ceiling. The White House has said that if there is no agreement by 22 July, then discussion about budget cuts and taxes should be abandoned in favor of legislation dealing solely with raising the debt ceiling before the borrowing limit is reached on 2 August. But the Republicans have rejected legislation without agreement on budget cuts.

With European leaders also facing a potentially ruinous debt crisis, a leading Wall Street figure described the prospect of a US default as catastrophic. Ben Bernanke, the chairman of the Federal Reserve, warned of a “huge financial calamity” if a political agreement is not reached. He told Congress a default would “send shockwaves through the entire financial system”. Moody’s, the credit rating agency, warned that it may downgrade the US’s AAA credit rating, because there is a “rising possibility” that no deal will be reached by next month’s deadline. China, the US’s biggest creditor, added to the pressure by publicly urging Washington to protect investors’ interests. The dollar continued its fall as investors shifted to other assets such as gold.

It seems that each side is determined to blame the other for a stagnant economy, with unemployment remaining stubbornly high at above 9%. The latest economic figures showed only a 0.1% increase in retail sales and a minor drop in the number of new jobless claims suggesting the rate at which companies are laying off workers is falling.

If the debt ceiling is not raised by 2 August, Obama will be forced to decide which parts of the government to shut down and which to keep going using continuing tax revenues, as well as how much of those revenues to direct to meeting payments to foreign holders of US bonds. The current US budget is estimated to meet a shortfall of more than one trillion dollars.

The president would have to decide whether to cut off unemployment benefits for those out of work and pension payments to the elderly. He might freeze the military payroll, a large expense but a move bound to bring stinging attacks from the Republicans. Many, if not all, government offices would close.

The Republicans propose $2.4tn in immediate spending cuts with no tax increases, as Guardian reported. Obama says the scale of those cuts demanded by Republicans can be reached, but only in several stages, and that tax increases are essential to reduce the deficit. Republican Senator Tom Coburn of Oklahoma, who dropped out of the bipartisan group of senators known as the “Gang of Six” after it failed to come up with a plan to reduce the federal deficit, released his own budget plan. This plan, which he called “Back in Black,” would cut $9 trillion – or roughly 20 percent of projected federal spending over the next 10 years – through a series of cuts, tax loophole closures and an increase on premiums for Medicare beneficiaries.

Prospects for a deal are undermined by divisions within the Republican Party. House Republican leaders believe much of the country will blame Obama for any economic consequences of a default on the debt. But the party’s Senate leadership is more skeptical.

The rhetoric about whether to raise the ceiling and under what conditions has been loud, harsh and, at times, misleading. A layperson needs to have some answers to common questions, as provided by CNNMoney, in order to understand the gravity of the looming crisis.

Debt ceiling is a cap set by Congress on the amount of debt the federal government can legally borrow. Its Pakistani counterpart if Fiscal Responsibility and Debt Limitation Act, 2005, which is never respected. The cap applies to debt owed to the public (i.e., anyone who buys U.S. bonds) plus debt owed to federal government trust funds such as those for Social Security and Medicare. The first limit was set in 1917 and set at $11.5 billion, according to the Center for a Responsible Federal Budget. Previously, Congress had to sign off every time the federal government issued debt. The ceiling is currently set at $14.294 trillion. The country’s accrued debt hit that mark on the morning of May 16. But by taking various extraordinary measures like suspending investments in federal retirement funds, total debt may be brought down enough to allow the government to continue borrowing until Aug 2, 2011. Hence, by the end of trade on May 17, total debt subject to the limit was a mere $25 million shy of the official cap — or $14,293,975,000,000. Total debt can fluctuate up or down on any given day.

Lawmakers tacitly agree to raise the debt ceiling every time they vote for a spending hike or tax cut. So in reality arguing over the debt ceiling is essentially arguing over whether to pay the bills the country has already incurred. But politicians who make a stink about the debt ceiling will always try to make the case that the guy who votes to raise it is a fiscal spendthrift. And politics, of course, permeates the whole debate. Lawmakers who want to make hay of the issue for political gain may push for a small increase so the debate comes up again soon. Others may want a bigger increase so they don’t have to revisit the issue for awhile.

Since March 1962, the debt ceiling has been raised 74 times, according to the Congressional Research Service. Ten of those times have occurred since 2001. Expect more of the same over the next decade. Barring major changes to spending and tax policies, “Congress would repeatedly face demands to raise the debt limit,” CRS wrote.

In theory, the limit is supposed to help Congress control spending. In reality, it doesn’t. Every time the debt limit needs to be raised, lawmakers and the president are forced to take stock of the country’s fiscal direction, which isn’t a bad thing necessarily. But the decision about how high to set the ceiling is divorced from lawmakers’ decisions to pass spending hikes and tax cuts. It’s also made after the fact, so it doesn’t do much to pull in the purse strings. That’s why budget experts say it would be better to tie the debt limit decision to lawmakers’ legislative actions.

What happens if Congress doesn’t raise the debt ceiling before Aug. 2? It is a 14 trillion dollars question. No one knows for sure. But the going assumption is that no good can come of it. Treasury would not have authority to borrow any more money. And that can be a problem since the government borrows to make up the difference between what it spends and what it takes in. It uses that borrowed money to help fund operations and pay creditors.

Secretary of Treasury, Geithner’s critics say he could prevent default by simply paying the interest due to bondholders. But since average spending — minus interest — outpaces revenue by about $118 billion a month, Geithner won’t be able to pay all the country’s bills. That means he will have to pick and choose who to pay and who to put off every day. And there’s no guarantee that paying interest while shirking other legal obligations will protect the country from the perception of default. Ultimately, if lawmakers fail to raise the ceiling this year, they will have two choices, both awful.

They could either cut spending or raise taxes by several hundred billion dollars just to get through Sept. 30, which is the end of the fiscal year. Or they could acknowledge that the country would be unable to pay what it owes in full and the United States could effectively default on some of its obligations. The first option would be impossible to execute without serious economic repercussions. And the second option could cripple the economy and send world markets into a tailspin.

“Not only the default but efforts to resolve it would arguably have negative repercussions on both domestic and international financial markets and economies,” according to the CRS.

At a minimum, a default could hurt U.S. bonds, the dollar and investors’ portfolios. “Our bond market and stock market would crash,” said former Congressional Budget Director Rudolph Penner.

Either option would not lead to a government shutdown which occurs only if lawmakers fail to appropriate money for federal agencies and programs. By contrast, if the debt ceiling is breached, Uncle Sam would still have revenue coming in that could be used to fund the government.

Spending on security (read: defense) so far constitutes the largest chunk of government budget. In order to fund wars in Iraq and Afghanistan, Presidents Bush and Obama have spent more than $1 trillion on direct costs alone. On top of that, annual defense spending has just about doubled since 2001, rising to almost $700 billion in 2010. Military spending now accounts for more 20% of the entire federal budget. Obama ordered more troops to Afghanistan in 2009, while he has simultaneously drawn down forces in Iraq. Costs are still sky-high. In February, Obama requested $118 billion to fund the wars just for fiscal year 2012.

Will the largest economy of the world end up being a mismanaged economy and will the US credit rating plunge further? Yes. The two misadventures in Iraq and Afghanistan are enough to cripple the economy. Apart from the fact that more than a trillion dollars in direct war costs has not bought the US what it wanted to buy and the Afghanistan drawdown is ending in near defeat, the post-endgame will entail even more enormous costs to deal with the catastrophe of instability the drawdown is going to leave behind. The journey from the Great Game to endgame will be so quick and short, nobody could visualize, not even the best of strategists.