The growing fear that there will be no deal is starkly illustrated by the fact that Senate Minority Leader McConnell (Republican) has proposed a new idea whereby the president could raise the borrowing limit on his own authority (in three stages) without receiving prior approval of matching spending cuts.

This suggests that McConnell is well aware of the train wreck that would result if the debt ceiling is not raised. He has good reason to worry.

When will the debt ceiling become binding? The current Treasury estimate is that the debt ceiling will become binding on August 2—that will be the date on which accounting maneuvers can no longer allow the government to keep spending more than its income without breaching the $14.3-trillion debt ceiling.

When must a debt-ceiling agreement be reached? The administration says that an agreement must be reached by July 22 in time to allow the necessary legislation to be drafted and passed. It is not clear how strict this deadline is.

What happens if the debt ceiling becomes binding? Simply put, the federal government's spending will be limited by its cash flow. Since government revenues fall far short of its spending, this means that there will be an immediate cut of 40–45% in government spending. This cut would amount to around $1.5 trillion at an annual rate (about 10% of GDP). The Treasury would have to decide who gets paid and who does not. We do not know what it would decide—there are no precedents. The first flashpoint would be $23 billion in Social Security payments due on August 3 (which revenues received that day would not cover).

Will the U.S. default? A debt default means that the United States fails to pay interest on its debt or to redeem maturing obligations. Since cash inflows are around $200 billion per month, while interest payments are of the order of $30 billion per month, if the Treasury decided to prioritize interest payments above other payments, it could make them. It could also refinance maturing debt, without raising the overall debt level, assuming that the markets are willing to lend.

What would ratings agencies do if the debt limit became binding? They would put the United States on watch for a downgrade (S&P has already done so). They would probably do this even before August 2. A missed payment on interest or redemptions would definitely mean a downgrade. There might be a downgrade even without missed payments.

What would be the effect on financial markets? For equity markets and the dollar, the impact would be unambiguously negative. Confidence in the ability of the U.S. government to fulfill its most basic responsibilities would be damaged. And the spending contraction, if sustained, would send the economy back into recession.

Interest rates would be expected to rise—but by how much is far from clear. Obviously, debt default or the risk of it would add a risk premium to Treasury yields, but at the same time there would be a massive fiscal contraction driving the economy into recession. And, once the debt ceiling is raised, U.S. Treasuries will probably still be the benchmark market yield, even if not rated AAA. So if interest rates do rise temporarily, investors will anticipate that they will fall back again once the immediate panic is over, which will limit the extent of that rise. This will also mean that short maturities would be hit harder (i.e., interest rates would rise more) than long ones.

But there would be massive dislocation in financial markets, because the recipients of government spending that fail to get priority, and do not get paid, will be unable in turn to meet their own obligations.

Bottom line? Debt default is not necessarily an immediate consequence of failing to raise the debt limit. Catastrophic spending cuts would be an immediate consequence, driving the economy into recession and financial crisis if the debt ceiling were not raised quickly.

The idea that it would be politically possible to implement such cuts for any length of time (beyond a day or so) remains hard to imagine.