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Could the U.S Government Default?

The U.S. ceiling is at risk of being breeched within the next several weeks, which would force a default if democrats and republicans cant agree on a new budget for 2012. Since the political battle threatens to be intense, it is hardly surprising that many observers fear a default. In fact, default is unthinkable and the players involved in the debate understand that, despite their public posturing. Moreover, the entire game is mixture of Kabuki theater and real budget priorities, a toxic mix of showmanship and substance. With Congress involved, the risk is that showmanship may trump substance, even if only briefly. And it is this possibility that led S&P to change its outlook to negative. At the end of the day, the political battles will add to market volatility, but even the politicians understand they cannot permit a default.

The very concept of having a debt ceiling makes no economic sense. Congress passes all tax and spending legislation, so why do they also need a limit on how much debt the government can issue, which is a direct result of their own budget decisions? No one passes budget legislation in the middle of the night behind their back. The debt ceilings purpose is to create an artificial crisis every time the ceiling is at risk of being breeched. What does it suggest about our governments budget process that an artificial crisis must be created to force Congress to address budget issues?

The looming budget debate will be particularly intense because it will be used by both sides to position themselves ahead of the 2012 elections. This will make compromise on significant aspects of the budget even more difficult. Both sides may feel obligated to stick to principles for the sake of establishing their position prior to the election, rather than makes concessions that suggest they are not true to their cause.

Despite the need the politics, a default cannot be tolerated. It is bad when the government fails to pass a budget and "nonessential" government operations must shut down. It is an entirely different matter when the government is legally unable to pay interest on its debt or unable to pay for critical obligations. Congress can prohibit the tide from coming in, but it will be extremely embarrassing when the tide arrives. Similarly, failing to pass a debt ceiling hike would be extraordinarily problematic and embarrassing. Both sides are likely to play Chicken and both have good reason to stick to their principles as much as possible prior to the election, but a deal is likely. Still, the process will not be pretty. In fact, the process will be downright messy, at least as bad as watching sausage being made. Welcome to the world of Washington, theater, and politics.

The decision by S&P to place the U.S. Government's debt on negative watch may help focus politicians on the consequences of failing to craft a plan for deficit reduction. S&P is recognizing that a significant deal is not likely prior to the election, which is already influencing how each side is approaching the debate. S&P's action will contribute to market volatility. With meaningful progress in drafting a plan for longer-term deficit reduction prior to the election, the U.S. Treasury market could easily turn ugly for bond investors, as heavy bond supply and a less accommodative Fed hammer Treasury, high quality corporate and muni bond prices.