Mohamed A. El-Erian: US politicians imperil economy

It has been raised more than 70 times in the last 50 years, mostly without commotion. It must be raised again this summer if the United States government is to continue paying its bills on time. But now, the US' debt ceiling has become the subject of intense political posturing and touch-and-go negotiations behind closed doors. And, obviously, the outcome has implications that go well beyond the US.

As part of America's system of checks and balances, Congress gets to do more than just approve the annual federal budget. It sets a limit on how much debt the US Treasury is allowed to issue, too. Beyond this ceiling, the government can spend only from current revenues.

US Treasury Secretary Timothy Geithner recently informed members of Congress that the government will be in this situation on or around Aug 2. Having already officially hit the ceiling, the Treasury is moving money around and tapping various pots of unused funds to pay its bills. In a few weeks, this "flexibility" will be used up. With the US government now borrowing about 40 percent of every dollar it spends, a truly binding debt ceiling would immediately force the government to reduce spending radically and in a disorderly fashion.

Politicians across the political spectrum know that such a situation would unsettle an already fragile US economy, severely weaken the dollar, and raise serious concerns about the country's ability to meet its debt-service obligations, including to the many foreign creditors that the US will need in the future. Yet, in today's polarized environment in Washington, Republicans and Democrats are unwilling to compromise - or at least to compromise "too early".

By holding out, Republicans wish to force President Barack Obama's administration into massive spending cuts. Democrats respond that such a one-sided approach would be economically harmful and socially unjust. In the meantime, both sides risk disrupting transfer payments (including to the elderly) and the provision of public services, as well as eroding further the US' global credit standing.

The overwhelming - and sensible - expectation is that the Republicans and Democrats will compromise and raise the debt ceiling before inflicting serious economic and financial dislocations. The most recent precedent was the bipartisan agreement reached earlier this year on another fiscal issue that threatened to disrupt the normal functioning of government: the absence of a formally approved budget for this year.

A compromise would allow both parties to declare partial victory, for it is likely to entail commitments to cut spending and some steps to make taxation more socially just. But, like many last-minute agreements, it will have little durable impact. In effect, the political system will again be kicking the can down the road, with real progress on necessary fiscal reforms expected only after the November 2012 presidential election.

Two scenarios for the timing of an interim compromise are possible, depending on whether it is a one- or two-step process. Most observers expect a one-step process for bipartisan agreement before Aug 2. But politicians may need two steps: an initial failure to agree, and then a quick deal in response to the resulting financial-market convulsions. In the meantime, the Treasury would temporarily re-prioritize and slow outgoing payments.

This two-step process would be similar to what happened in 2008, when Congress was confronted with another cliffhanger: the George W. Bush administration's request for $700 billion to prevent a financial-market collapse and economic depression. Congress initially rejected the measure, but a dramatic 770-point drop in the stock market drove politicians back to the table - and to an agreement.

But the two-step scenario involves incremental risks to the US economy, and to its standing in the global system. And the longer America's politicians take to resolve the debt-ceiling issue, the greater the risk of an inadvertent accident.

This brings us to a third, and even more unsettling possibility: a longer and more protracted negotiation, resulting in greater disruptions to government entitlement payments, other contractual obligations, and public services. Creditors would then ask many more questions before adding to their already-considerable holdings of US government debt, generating still more head winds in a US economy that already faces an unemployment crisis and uneven growth.

The next few weeks will provide plenty of political drama. The baseline expectation, albeit subject to risk, is that Democrats and Republicans will find a way to avoid disruptions that would damage the fragile US economy, but that the compromise will not meaningfully address the need for sensible medium-term fiscal reforms.

Such political paralysis on key economic issues is increasingly unsettling for the US private sector, and for other countries that rely on a strong US at the core of the global economy. This helps to explain why so many companies continue to hoard cash, rather than invest domestically, and why a growing number of countries want to diversify gradually away from dependence on the dollar as the reserve currency and on the US financial market for intermediation of their hard-earned savings.

The world economy is hard-wired to the assumption of a strong US, and Americans benefit from this. But the more US politicians argue over the debt ceiling, the greater the risk of that wiring becoming irreparably frayed.

The author is CEO and co-CIO of PIMCO, and author of When Markets Collide.