As Aug. 2 Deadline Nears, Debt Crisis Looms

The results of default would be disastrous for an already faltering economic recovery. Congress is notorious for being unable to meet deadlines. Even in good years, congressional inaction plays havoc on states, leading to annoyances like stalled transportation projects and emergencies such as budget-busting Medicaid payment delays. Failing to act on the debt ceiling would yield similar results, and some far worse.

The most immediate consequences will be felt in the stock market, already struggling in advance of the Aug. 2 deadline. However, the skittish market of the past week will seem bullish if the credit rating agencies make good on their warnings of a possible downgrade of U.S. debt. State and municipal issuers have already been put on notice that their ratings will also dive if the U.S. loses its AAA rating. Such a downgrade could cost the federal government as much as $100 billion in increased borrowing costs, with states and localities absorbing billions more in increased debt service.

In the event of a default, the Federal Reserve would be compelled to raise interest rates. In addition to affecting anyone in the process of buying a home, car or seeking a student loan, this would likely choke off the country's anemic economic growth and reverse the modest increases in tax receipts that most states have enjoyed over the past few months.

Simultaneously, the Department of the Treasury would be forced to hoard cash to cover debt service, Social Security checks, military salaries and other key payments. A recent study by the Bipartisan Policy Center noted that federal tax revenues for the month of August would only be able to cover 44 percent of the government's outstanding liabilities. To maintain payments for even the most critical services, policymakers would be forced to radically curtail funding for Pell Grants, unemployment insurance and many other important programs.

Any steep drop in federal spending would have an immediate impact on states. A report by the Pew Center on the States noted that state and local governments received $478 billion in federal transfer payments in 2010 alone. A federal default would place large swaths of this funding in jeopardy, affecting everything from special education to transportation.

Both Congress and the president know it is imperative to avoid default. Whether it is House Speaker John Boehner's plan to increase the ceiling in the short-term and implement long-term cuts through a two-stage process, a similar proposal by Senate Majority Leader Harry Reid which would extend the debt ceiling through the end of 2012, or Sen. Mitch McConnell's dark horse option of delegating both the authority and the political responsibility for the increase to the president, there remain viable options to resolve the impasse.

Given the scale of state and local grants in aid, any grand compromise to reduce the deficit will necessarily entail significant reductions in state funding. Howeverthe impact of such cuts, likely spread over a 10-year period, would be far less damaging to state finances than a default crisis.

The president and House leadership, who took office with very different political mandates, remain on different pages when it comes to the debt ceiling. This difference ensures that the decision will go down to the wire. As the deadline approaches, the pressure to cut a deal will increase exponentially. When it comes to the debt ceiling, the most irresponsible action is definitely inaction.

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