Humans possessed with rational powers of reason continually fail to grasp that our native sub-human species known as homo politicianus is not actually occupied at all with the "problem" of solving the debt crisis. Politicians have no interest in solving problems--they are interested in political advantage. However, politicians, like wayward teenagers, forget that there is a price to be paid for a wild binge of saber rattling and muscle flexing. The hangover is the prospect of the permanent loss of the ability to save face and to survive to fight another day.
In any successful negotiation with children (and politicians resemble nothing so much as children with limitless power), as Dr. Thomas Gordon teaches us, the way to achieve cooperation is not through compromise, but to the contrary, by creating solutions that ensure that everyone's needs are met. In international relations, such an approach might be termed political realism, or Real Politik.
But before we create such a solution, we need to clearly identify Democrats' and Republicans' actual needs. And we will find that the actual need of both parties is not to solve an impending debt crisis, but is actually to save face and to be able to declare victory to the American public.
To save face, Democrats need to successfully reopen and to fund government without being perceived as giving in on the implementation of the Affordable Care Act. In order to declare this victory, they have signaled that they are willing to agree to temporary measures to fund government that both meet their short-term needs and give some continuing leverage to Republicans to continue negotiations on a host of issues.
To save face, Republicans need to successfully be seen to extract tangible policy compromises from Democrats in Congress and from the President. However, the implicit and unstated need of Republicans is not to actually block the implementation of the Affordable Care Act. Even the most fervent ideologues privately recognize that they must utilize traditional legislative means to oppose bills, as opposed to means which are viewed by the public as coercive. To save face, and to declare reopening government as a victory, Republicans need to only extract policy compromises on other unrelated social programs or budgetary issues.
If Congress and the President were to agree to compromises on other policy/budgetary issues, rather than on the Affordable Care Act itself, the Democrats and the President could declare victory by having kept their promise to refuse to make concessions on Obamacare, and Republicans could declare victory by pointing to tangibly successful negotiations on other policy/budgetary issues.
Realistically, Republicans could offer a short-term increase in the debt ceiling as part of a package, so that they could keep some negotiating leverage for a wider structural fiscal debate. Moreover, the President could frame the acceptance of policy concessions as being contingent upon concurrent Republican agreement to a short term debt increase, thereby keeping his promise not to negotiate under threat.
Such an outcome would be wildly reassuring to markets, and could result in a strong rally, if cooler heads prevail. Bond markets (TLT) would be calmed, stocks would rally (SPY), volatility would plunge (VXX), and the dollar (UUP) would stabilize. However, there is another perspective to keep in mind. When the famous value investor Irving Kahn was asked the secret to surviving the Great Depression, he said the secret to surviving was always assuming that everyone would do the wrong thing.
In which case, stocks will plunge, bonds will also fall, the dollar will sink, and volatility will skyrocket even more than usual during crashes, because the traditional hedge of long bonds will be entirely ineffective due to skyrocketing interest rates.
Homo Politicianus has devolved, and there is absolutely no evidence that young politicians have any capability or desire to create solutions that ensure that everyone's needs are met and help each side to save face. Contrary to the usual adage, the reality is that it is hard to teach new dogs old tricks.
Can Congress and the President engage in Real Politik? I certainly hope so, but I would have more luck betting on horses at the race track. And other investors agree, which is why they refuse to play in markets which increasingly resemble casinos in which the only predictable jackpot is the very real prospect of ruin.