Next Stop: Economic Armageddon?

As you probably have heard by now, our political leaders are engaged in epic negotiations after the Republican majority in the House of Representatives announced that it would not vote to increase the debt ceiling without major spending cuts. Unless Republicans and Democrats reach a deal to increase the debt ceiling by July 22, so that a bill can be passed by Aug. 2, the government will probably default, and many believe it'll be economic Armageddon, take two.

So how are those negotiations going, and what does it all mean for individual investors, you ask?

At a financial summit at the White House a few weeks ago, I had the chance to hear from coffee-toting Gene Sperling, one of the White House's lead negotiators. He said that both sides agreed to make a substantial "down payment" toward $4 trillion in deficit reduction, but that the White House believed that some of the deficit reduction would have to come from ending tax breaks.

He was referring to "tax expenditures," which cost $1.1 trillion per year, and mainly benefit the wealthy. Including tax expenditures in a deficit deal, Sperling argued, was necessary not only to generate enough savings, but also because "we need the moral authority to ask for shared sacrifice. ... People won't accept [cuts to domestic services] if it feels like it's to pay for $700 billion-$800 billion in tax breaks for the wealthy."

According to ABC News, the basic outline of the deal would have been 5-to-1 spending cuts to revenue increases, as follows:

The White House would agree to $2 trillion in spending cuts over the next 10 years, including...

• $200 billion in cuts to Medicare and Medicaid.
• $200 billion in other mandatory spending cuts, including areas like farm subsidies and federal pensions.
• $1 trillion in cuts to discretionary spending, including the Pentagon.

In return, they wanted $400 billion in revenue increases over the next 10 years, including...

• $3 billion for eliminating tax breaks on corporate jets.
• $20 billion for eliminating the "carried interest" loophole that allows hedge fund employees to pay a 15% personal income tax rate.
• $45 billion in cuts to oil and gas subsidies.
• $60 billion in from ending tax breaks for LIFO inventory accounting.
• $290 billion for capping at 28% the tax write-off those making more than $200,000 can claim on itemized deductions.

When I saw Sperling, he exuded measured, cautious optimism about the possibility of reaching an agreement among the negotiators: "There is a seriousness of purpose in deficit meetings. ... [Virginia Republican Rep.] Eric Cantor is well-prepared, as is everyone else. ... [But] nothing is agreed to until everything's agreed to."

You can say that again
Fast-forward one month. Republican leadership has left the talks, arguing that no tax expenditures should be on the table. Here's how Cantor put it:

I believe that we have identified trillions in spending cuts, and to date, we have established a blueprint that could institute the fiscal reforms needed to start getting our fiscal house in order. That said ... Democrats continue to insist that any deal must include tax increases.

With the negotiations broken off, both sides took their cases directly to the public. House Republicans didn't want to end the tax breaks. The White House didn't want to reduce the deficit entirely by cutting spending on social programs without the wealthy chipping in by giving up some of their tax breaks, too. Senate Democrats don't want to cut Medicare and Social Security unless it's part of a broader deal that would probably include expiration of the Bush tax cuts for the wealthy.

No one knows for certain what would happen if the debt limit doesn't get raised. The director of economic and market analysis at Citigroup clarified that, "Asking what the U.S. economy might look like after a possible U.S. Treasury default is akin to asking, 'What will you do after you commit suicide?'" But here are the sorts of things we could look forward to:

• The Treasury would decide between not paying bondholders, or taking other measures like skipping Social Security payments and deferring troop salaries. The missing payments would cause "enormous disruptions" for the economy, as Warren Buffett puts it. A double-dip recession would be pretty likely.
• Moody's is considering downgrading U.S. debt to Aa. That's about in line with Italy, Spain, and Japan. Rate spreads between U.S. and those nations' long-term interest rates indicate that the cost to the U.S. could be as high as $100 billion to $200 billion in annual interest payments. The Economist estimated an annual cost of about $86 billion. However you slice it, the direct costs of a downgrade or default would be high.
• In addition to a deeper economic downturn and higher deficits, a downgrade or default could also trigger another financial crisis. Treasury bonds are not only investments, but also comprise much of the blood of our financial system. If banks begin to question each other's liquidity and solvency, they'll pull the plug on each other like it's 2007.

Companies that employ significant short-term financing, from financials such as Annaly Capital (NYSE: NLY) and American Capital Agency (Nasdaq: AGNC) to conglomerates such as General Electric (NYSE: GE), could be crushed by a freeze-up in credit markets.

But here are the five biggest holders of Treasury bonds:

Source: Capital IQ, a division of Standard & Poor's, and the Federal Reserve Bank of New York. All numbers in billions.
*Excludes securities held-to-maturity.

If these banks go under, no one is safe. Shorting U.S. Treasuries might be profitable. As of the most recent filings, Cantor owned ProShares UltraShort 20+ Year Treasury (NYSE: TBT). But a total financial collapse could also hurt the ETF's counterparties. Similarly, gold would probably do quite well, but some gold producers could be destroyed in a financial panic.

There are ways this could all be avoided. Here are two of the most likely:

• Voters (or Wall Street) force a compromise: This is actually how the last debt ceiling crisis was resolved. From 1995 to 1996, then-Speaker Newt Gingrich (R-Ga.) threatened to refuse to pass a debt limit increase, until he changed his mind after Social Security checks began to be affected and Moody's said it would consider a downgrade.
• Agree to live to fight another day: On Wednesday, Senate Minority Leader Mitch McConnell (R-Ky.) suggested an intriguing proposal: Give the president the authority to raise the debt ceiling on his own (unless overridden by two-thirds of both chambers of Congress). Everyone would get what they want: The Treasury can pay its bills; Democrats don't agree to cut Medicare and Social Security without the wealthy giving up tax breaks; Republicans don't have to face the choice between ending tax breaks for the wealthy, raising the debt ceiling, and political annihilation from blocking the raise; and everyone else avoids economic collapse.

Nothing is agreed to until everything is agreed to. But I'm optimistic that either a compromise, or, more likely, something like McConnell's plan will probably be employed. Why? Because default would be economic -- and political -- suicide.

What do you think we will or should do with the debt ceiling? Sound off in the comments box.