Beware of economists making political predictions!  Nonetheless, I suspect there is now less than a 50% probability any deal will be reached to raise the debt ceiling and wonder what fool linked budget negotiations to the debt ceiling anyway.

Does that mean the U.S. will default on its debts for the first time?  No, I don’t think so.  There will be plenty of money to keep the bondholders happy but not Americans.  It is a “Sophie’s Choice,” but the right thing to do in the long run is to protect future generations by putting bondholders before this generation.  Demand for goods & services will drop, making the fragile recovery more difficult.

Does that mean the U.S. will keep its credit rating?  I doubt that is possible any longer.  All three ratings agencies evaluate governance, for countries as well as companies.  With a AA rating, interest rates will increase.  That is not the end of the world, as it happened to Japan in the late 1990s, and they survived, albeit in a weakened state.  The longer the maturity, the greater the increase in interest rates.  So, it won’t be good for the vulnerable housing market.  Already dead weight on growth, recovery will just be that much more difficult.

What will happen to the dollar?  It is already falling rapidly, and I expect it will fall even more after the credit downgrade.  However, as interest rates begin to rise, the dollar should make a brief rally, before continuing its long term decline.  Long term, this will be good for our exporters.

Is this a debacle?  Well, some well-meaning soul will tell us that “making sausage is not pretty.”  Agreed, but making sausage is at least productive.  Congress is destructive!  Linking the budget negotiation to the debt ceiling was simply stupid. 

Remember:  the first step in a twelve-step recovery process is to admit there is a problem.