The stock market looks highly vulnerable to a major downturn no matter how the debt ceiling issue is resolved. Although anything we write about the controversy could be moot by the time you read this, here's how it looks now. Once the symbolic Boehner and Reid proposals are rejected congressional leaders will attempt to come up with a compromise between the Boehner and Reid plans over the next few days. The talk from Washington is that the two sides have already been working on this even prior to the votes. While the odds are that the debt ceiling will be raised, it is far from a sure thing. With so little time remaining there are now only two possible outcomes----it either gets done or it doesn't. If the debt ceiling does not get raised in time to avert a default it is an obvious disaster for the market and the economy. So there's nothing more we can add about such an outcome.
However, a settlement of the dispute at this late date is no panacea either. Neither side is likely to get anything near what they want. The cuts in spending will be relatively small and there will be no tax increases. A downgrade in the U.S. credit rating would be probable with a highly uncertain outcome. Moreover the whole issue will probably end up being kicked down the road and be reconsidered again well before the 2012 elections. This prospect will therefore continue to hang over the economy and the market like the "sword of Damocles" for a lengthy period of time. Economic growth, already anemic, would slow down even more or enter recession. The lower the growth rate the higher the budget deficit and the larger the increase in debt. This result would probably call for even more spending cuts causing even slower growth and more debt----the classic negative feedback loop.
Just as importantly, the political jousting in Washington has engendered widespread doubt on the ability of the U.S government to function and cast doubt on the competence of our political leaders. The U.S. still has the ability to pay its debts and foreign creditors have still been investing in U.S. debt instruments at historically low interest rates. Simply put, there was no crisis until it was self-created in Congress. This congressionally-created crisis will lead to another drop in confidence on the part of consumers, business and foreign nations. Certainly there is far too much debt, both household and government, in the U.S. and we have been in the forefront of those pointing it out. But the totally incompetent way the issue has been handled is likely to have extremely negative consequences for the economy and markets.