Debt deal: Out of the fire, into the frying pan?

(MoneyWatch) For congressional leaders jawing over a bill to temporarily reopen the federal government and avert a U.S. debt default, the high cost of failure is clear. But the cost of success in this case is also high, experts say, with the seemingly chronic dysfunction in Washington potentially sowing economic uncertainty for months to come.

"Whatever deal is delivered is only going to postpone things for a few months," said Ed Yardeni, president and chief investment strategist for institutional investor advisory Yardeni Research.

Congress faces a Thursday deadline to raise the government's debt ceiling, and as of Tuesday afternoon lawmakers remained divided on a plan to end the standoff. A proposal from Senate leaders to fund the government through Jan. 15 and renew the nation's borrowing authority through Feb. 7 appeared stalled amid opposition from some House Republicans.

The impact of the latest debt battle on the economy is already making itself felt. Although most forecasters expect only a marginal hit to growth if the government shutdown ends soon, Ian Shepherdson of Pantheon Macroeconomics thinks the damage is done. He expects growth of 1 percent, or less, in the final three months of the year, a marked slowdown from earlier in the year, and for the pace of job-creation to lag until early next year.

To be sure, even a short-term increase in the debt ceiling would stave off disaster. Analysts warn that a U.S. default would throw the country into recession, torpedo financial markets and slam the global economy. But they also worry that the terms being discussed in Washington could deepen the divide because it could condition future increases in the debt ceiling on broader agreements between Republicans and Democrats on fiscal issues.

Such compromise has proved elusive. During the 2011 debt ceiling fight, lawmakers created a "supercommittee" to hammer out a bill on taxes and spending. It failed, setting the stage for the sequester, the massive cuts in federal spending that took effect in March and that economists say have reduced economic growth.

Meanwhile, returning the focus on Capitol Hill to deficit-reduction could undercut growth at a time that economic demand remains weak. "We're in the middle of severe budget cuts already," said Richard McGahey, an economist and professor of public policy at the New School, in a discussion to discuss the impact of the budget crisis. "The economy is slowing down."

The upshot: With more than 11 million Americans still unemployed, the slowest economic recovery in U.S. history may bog down even more. "The authorities have caused this mess and keep rounding up other suspects for why the economy isn't growing as it should and creating jobs," Yardeni said. "But they are the guilty parties."

If there is a silver lining, it is that a short-term compromise on Capitol Hill over the shutdown and debt limit could forestall further conflict next year. Increasing the debt ceiling until Feb. 7 would allow the government to issue more debt than it needs early next year, said Paul Ashworth, chief U.S. economist with Capital Economics. With some creative accounting, that funding would allow the U.S. Treasury Department to meet its obligations through early March. The government's coffers would be replenished in April as tax receipts flow in.

By then, lawmakers will be in the thick of their midterm election campaigns, raising the risks of playing chicken over the nation's finances. "Do Republicans want to trigger a shutdown if they're going to get blamed that close to the midterm elections?," Ashworth asked.

Although both political parties are drawing fire for their handling of the budget negotiations, recent polls suggest more Americans blame congressional Republicans than Democrats for the impasse.

Despite the rising concerns among U.S. consumers and businesses, the impact on overseas investors could be more muted. That's because, despite the logjam in Washington, the U.S. remains a financial safe haven for a range of institutional and sovereign investors. Interest rates on U.S. Treasury bonds have crept up in recent days, particularly on short-term debt as investors have grown anxious that the government could miss payments, but yields have remained in check.

"If you're a massive pension fund, [overseas financial] markets aren't big enough to satisfy the size of assets you're looking to hold," Ashworth said. "The Chinese have accumulated their large stock of Treasuries as payment for their trade surplus with the U.S. If they stop buying U.S. securities, then the other side is that the U.S. will stop buying China's goods."