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Ask Jay Powell how the average consumer would be affected if Congress doesn't vote to raise the debt ceiling before Aug. 2, and he responds with his own question:

"Did that consumer lose his job?"

That's a good possibility if the consumer happens to work for the federal government, for a defense contractor that doesn't get paid or for a company that needs credit to keep going.

It could also be big trouble for anyone who needs a car, needs a home or student loan, uses a credit card, has a retirement savings account or wants to travel abroad.

Not raising the limit on how much the U.S. government can borrow -- now set at $14.3 trillion -- would be "an enormous economic event," said Powell, who was undersecretary of the Treasury for the first President Bush and now works at the Bipartisan Policy Center, a Washington, D.C., think tank. He is an author of the center's analysis of the debt-limit situation (.pdf file).

The analysis estimates that without authorization to borrow, the federal government would take in about $203 billion in revenue but have $362 billion in bills to pay.

So choices would have to be made on what got paid. Interest on outstanding debt would take priority to avoid default and damage to the U.S. credit rating. Beyond that, should the government pay Social Security benefits but not the salaries of servicemen and servicewomen on active duty? Medicare and Medicaid payments but not federal workers' salaries and benefits?

The U.S. government has 80 million bills due in August, and, no matter what choices are made, about 40% to 45% of them won't get paid unless more borrowing is authorized.

"When you take away all that spending, it will have a huge effect on the broader economy," Powell said.

Impact on interest rates

And if the U.S. government doesn't pay back the $500 billion in debts coming due in August -- or at least pay the $29 billion in interest on those loans -- that default is going to cause havoc in the economy's credit sector, which will eventually reach down to anyone who needs to borrow money or uses a credit card.

How much interest is charged on a loan is determined by an assessment of the chances of the money being repaid. Lending money to the U.S. government, by buying Treasury bonds, has been rated as one of most risk-free investments available, which means the government pays a small amount of interest on the money borrowed.

Moody's Investors Service, Standard & Poor's and Fitch have said that a default would prompt them to downgrade the United States' credit rating from the top-ranked Aaa. But simply raising the debt ceiling, without getting the nation's debt problems under control, might not be enough to prevent a downgrade, the ratings agencies have indicated.

Treasury bonds provide the floor for other lending -- car and home loans, credit card debt and student loans, for instance. And because those loans are seen as more risky, the interest charged on them is higher and could rise faster than an increase in the rate on U.S. securities.

How much those interest rates might go up would depend to a large extent on perception, said John Praveen, the managing director of Prudential International Investment Advisers in Newark, N.J.

"It's not so much how much but how fast" interest rates change, he said.

For example, if the rate on 10-year Treasury bills went up half a percentage point, Praveen doesn't think there would be much impact, since the rate is low already (3% to 3.5%). But if the rate increased quickly by 1 or 2 points, the perception in the equity markets would be that the rate would keep going up.

"There would be uncertainty because you don't know if the increase will continue; you don't know the endgame," Praveen said.

A 1% spike could cause problems. For example, Praveen said that given the high correlation between mortgage rates and the Treasury yields, homebuyers could expect a one-to-one increase in mortgage rates.

A worst-case scenario

Other negative effects could include a sell-off in the equity markets, which could hit retirement accounts hard. Banks could stop lending to each other and to consumers, preferring to hang on to assets rather than risk them by lending. A sharp decrease in spending by wary consumers could mean that the economy, weak already, could falter further. All of these scenarios, Praveen said, could build on themselves, and the snowball effect could send the economy back into recession.

It is this "fear factor" that Praveen sees as having the most potential for damage.

Praveen was quick to point out that this would be a worst-case scenario he saw as highly unlikely. He predicted that the nation's leaders will stop acting like "little children" and that an agreement will be reached to raise the debt ceiling. Even if that does not happen by Aug. 2, Praveen said he expects an agreement within a couple of days after that date.

"A short shutdown would not mean a lasting event," he said. "There would be a one- to two-day sell-off in the markets, and that's it, before things start getting back to normal."

Again, perception would be key -- in this case, perception of how long a government shutdown would last, of how long it would be before some agreement is reached on spending and/or borrowing.

"We'd be living at the four-way intersection of finance, politics, symbolism and psychology," said Paul Palazzo, the managing director of financial planning at Altfest Personal Wealth Management in New York. "A default would almost certainly result in higher uncertainty and anxiety, none of which is generally good for consumer confidence. But there doesn't have to be lasting damage. . . . In an uncertain environment, the movement of money could well slow down. But again, the question is, What time frame are we talking about -- days, weeks, months?"

Powell, of the Bipartisan Policy Center, told CBS News last week that even a short shutdown could cause a "lasting blemish" on the U.S. credit record, making future borrowing more costly for the U.S. government and resulting in more debt for taxpayers to repay. But Powell and Praveen agreed that any negative effect on the U.S. dollar's value would be cushioned by the debt crisis in Europe.

"The euro is already weakening," Praveen said, "and with two currencies in weakening trends, you could see strengthening of some other currencies -- the Japanese yen, for instance."

A weaker dollar makes U.S. goods cheaper, but Praveen points out that the benefits to U.S. exporting would be muted. "Even if U.S. goods are cheaper, with a general recession worldwide, then who's going to buy?" he asked.

Because the dollar is unlikely to weaken against the euro, trips to Europe may not become more expensive. However, Praveen said, some currencies could get stronger against the dollar, and trips to Asia, Brazil, Canada and Mexico would become more expensive.

"That may lead some Americans to cancel their summer trips abroad or spend less when they travel," he said.

Another effect of a weakened dollar would be that goods imported to the U.S. would not be as cheap as they are now. That could include items from China, although Praveen said there's a caveat there. The Chinese currency is controlled by the Chinese central bank, which might choose to keep the exchange rate intact so that Chinese goods remained attractive to U.S. consumers.

What should investors do?

Despite all the potential negative consequences of not raising the borrowing limit or reducing federal spending, Altfest's Palazzo is telling his clients there wouldn't have to be fundamental damage to the economy.

"We are telling clients to stay the course," he said. "It is true that if the situation isn't resolved, markets could go down. It's also true that if it is resolved, they could go up. . . . We believe portfolios should be designed for the long term, in a way that enables clients to withstand the fluctuations that come along the way."

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Estimates of retirement-account losses in 2008 range from 22% to 33%. But that incoming wave of the recession might have served as a warning to retirees to adjust the holdings in their accounts to protect against another dip. Losses in individual accounts because of a U.S. borrowing crisis would depend on the structure of those accounts -- how much was invested in stocks, credit instruments and other holdings.

An advisory to clients issued this week at Merriman, a financial-planning company based in Seattle, had much the same advice as Palazzo's, noting that "despite a subsequent worldwide major economic crisis, and with continuing worries about the anemic recovery, sovereign debt and the U.S. deficits, most of our composites are above their previous October 2007 high."

The advice to clients was to:

  • Keep some cash on hand for emergencies.
  • Maintain a well-balanced and thoroughly diversified portfolio.
  • Rebalance your portfolio periodically.

Perhaps the bigger threat to the economy is the psychological factor that would be operating if the debt ceiling isn't raised.

"If people didn't get their Social Security checks, that would not be good," Palazzo said. "If people felt that government had become so dysfunctional that it couldn't carry out day-to-day responsibilities, then the symbolism could potentially be a lot more damaging in the long term than a missed check."

At least one consumer has suggested a way to use that symbolism -- along with some real consequences -- to bring an end to the wrangling over the debt ceiling. Pamela Clair of Toledo, Ohio, posted this suggestion to friends on her Facebook page and asked them to pass it on:

"Instead of threatening to withhold Social Security payments of people who really need the money, let's hold the paychecks of all House and Senate members, then see how fast it is resolved!"

Clair hopes her mini-movement will get the message across to higher-ups.

By Aug. 2? We'll see.