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If the debt ceiling talks fail, is August 2 really the drop dead date for a U.S. default? Perhaps; the President has said that the Congress needs a deal by July 22 to get legislation through Congress by August 2. I don’t buy it.

As long as a deal is struck by August 2, something can be patched together. However, the President and Treasury Secretary have so convinced most everyone that Treasury will be out of money by August 2 that a week before, interest rates investors demand on Treasurys may rise precipitously on the bond market routs. At that point, there may be no turning back.

It is unfortunate the President and Treasury Secretary are spreading around calamity scenarios, because the Treasury really does have options after August 2 if it doesn’t scare the markets into panic before then.

The Treasury will still be receiving 55 percent of its tax revenues and can easily pay the interest on the debt, and should then be able to roll over bonds coming due. For the balance of Federal expenses, the Treasury will have to prioritize, but it will have enough money for Social Security, Medicare and Medicaid. Some checks may have to be spread out to accommodate discrepancies between payment dates and cash flows, but interest payments are modest enough, relative to the total cash coming in, that those can be met on time.

Selective payment of federal bills is possible — it was planned for government shutdowns when the Congress and President failed to approve appropriations — and it can be accomplished again if planned prior to August 2.

If no other sources of funds are found, the bond rating agencies have indicated failure to pay vendors and contractors on time would result in a downgrade in U.S. government’s AAA rating; that is likely to happen, but a downgrade is not a default. As long as interest is paid on the bonds, the United States has not defaulted on the national debt.

A downgrade is likely no matter what comes out of current negotiations. Specifically, Standard and Poor has indicated a $4 trillion deficit reduction package is necessary by August 2 to avoid a downgrade. That simply is not possible, given the President’s aversion to genuine spending cuts — evidenced by his failure to table concrete spending cut proposals — and the insistence on no new taxes by many members of the Republican House caucus.

Also, S&P is assuming a 3 percent GDP growth rate in projections of the future revenue, spending and debt to GDP ratios. Three percent growth is not likely to be attained this year or next without pro-growth reforms the President is ideologically opposed to accepting. This will all come to a head in February, when the administration publishes its FY2013 Budget proposal and 10-year deficit projections.

Funding could be found for the remaining 45 percent of expenses. Consider the minuet the Treasury and Fed were dancing through June 30 under QE2. The Treasury printed and sold bonds to the public, and the Fed printed money to buy up most of those bonds. Simply, the Fed monetarized most of the new debt from November to June. The Fed currently holds $1.6 trillion in Treasurys and over $2.6 trillion in Treasurys, federal agency bonds, and mortgage-backed securities. Roundabout, under QE2, the Treasury and Fed were printing money to pay more than a third of the government’s bills.

On August 2, the Treasury may not be able to print and sell bonds, but it too can print money to pay its bills. That would flood markets with cash, but the Fed can mop up the excess liquidity by selling off the bonds it has accumulated these past seven months. (It is important to note that the bonds the Fed holds already count against the debt ceiling; selling those to the public does not pierce the ceiling for the purposes of the statutory debt limit.) Whereas through June, the Treasury printed and sold the bonds and the Fed printed the money and purchased most of those bonds back, now the Treasury can print money to pay its bills, and the Fed can sell the bonds to mop up most of the new money.

Irresponsible? No more so than QE2, and much less so than letting the U.S. default on its debt or leaving grandma without groceries. The Fed balance sheet could carry us through the next election, no problem.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Funding the Government After August 2: Running QE2 in Reverse