The debate over an extension of the debt ceiling remains the central focus of financial news and has generated an increasing level of heated comments and extreme predictions as the self-imposed August 2nd deadline by the Treasury comes clearly into view. It is the prime cause of the increased volatility of the financial markets. No one really knows if an agreement will be reached by that date. For that matter, no one really knows what is likely to occur even if an agreement is not reached. However, the extreme predictions are unlikely to occur.
There are two sides to the debt question, the political side and the financial side. Politically, both sides have dug themselves into a “no-compromise” position. It becomes increasingly impossible to back down even a little from this position. A compromise, if it is worked out, will satisfy no one and the whole question of entitlements and meaningful reductions in government spending will be left to the next election. As of this writing the likelihood is that no agreement will be reached. Under this scenario, despite the screams of anguish, the government will continue to pay its bills, the debt may be downgraded, and life will go on. Grandma will not be thrown out into the snow, and the military will be paid. The war will go on. Volatility will be intense for a while, but the course of the economy will ultimately be the driving force in the markets.
The financial side is the more enduring. Short term there is a psychological impact. If failure to agree on a compromise causes the consumer to retrench further, the risk becomes a return to recession. This isn’t likely to happen unless the slow but steady improvement in new jobs reverses. The economy is still growing and receiving a tailwind from export growth, agriculture, and industrial strength. The building blocks of expansion continue to fall into place. Internationally, the dollar will remain the reserve currency because the U.S. remains the largest and wealthiest economy in the world. No other currency has the liquidity, size, or acceptability of the dollar. This is true whether or not downgrade occurs. In time, the financial outcome will detach from the political expressions, which are based entirely on short-term perceptions.