THE deepening of the Eurozone debt crisis through contagion, spreading to Italy, was more than matched by the growing chance that the US would not be able to pay its bills or service its debts starting Tuesday.
President Barack Obama and the Democrat and Republican party leaders were engaged in negotiations to avert a partial closing down of the government. The US has a limit to its federal debt of $14.29 trillion that will be reached by Tuesday. Congress has to approve raising the limit before then, or the administration will have to postpone meeting some of its financial commitments.
Federal Reserve chairman Ben Bernanke warned that default would send shockwaves throughout the global economy. Rating agencies Moody's and Standard and Poor's warned they might downgrade US debt from its AAA status if the political impasse continued.
There are reasons why the world, especially the developing countries, should be alarmed.
First, many developing countries hold many billions of dollars of US Treasury bills as part of their foreign reserves. A default raises the prospect of them having to take a haircut, being only paid back a part of their bonds. This is unlikely to happen.
But even the prospect of default and a credit status downgrade would reduce the value of their bonds. The recent decline of the dollar's value will likely accelerate, causing further losses. This triggered China (which holds $1.15trn in Treasury bonds) to urge the US to adopt responsible policies and measures to protect investors of US bonds.
Second, economic growth in the developing economies will be hit if the stand-off or the eventual solution causes the US economy to move to a standstill or a new recession.
Whatever the deal between the president and the two parties, its centrepiece is certain to be deep cuts in government spending. This will reduce demand in the economy. The effect will be opposite to the recession-busting fiscal stimulus that enabled the economy to bounce back after the 2008-09 recession.
Third, the uncertainties in the US emphasise the unhealthy dependence on the US dollar as the international reserve currency. The need for reform to reduce this dependence on one currency, for example, by greater use of the special drawing rights (a basket of major currencies) as a global reserve currency, has been advocated by economists and policy makers.
The facts of the impasse are as follows:
The debt limit of $14.29trn is forecast to be reached on Tuesday, so no new loans are allowed after that.
The administration estimates that the limit has to be increased by $2.4trn to meet its commitments up to November 2012, after the presidential elections.
Many Republicans in Congress, especially those under the influence of the Tea Party group, want the government to achieve budget balance by slashing spending without any tax increases.
A few Republican leaders, however, are willing to consider a small increase in taxes, or rather in closing tax loopholes, but are finding difficulty in convincing their colleagues. They also want spending cuts to exceed the rise in the debt limit.
The president and Democrats are willing to cut spending, but want to raise taxes of the rich, so both can contribute to the deficit reduction. Democrats are adamant social and medical security should not be affected though Obama is willing to allow some cuts there as well.
If the extreme stance of the Tea Party faction becomes the overall Republican line, a deal would be difficult. To meet it, the Democrats and president would have to move their compromise position to total capitulation.
If the deadlock continues, a possible solution may be the proposal of Senate Minority Leader Mitch McConnell: the president submits his plan to increase the debt limit and cut the budget, the Congress rejects it, the president vetoes, and his proposal is adopted unless two-thirds of Congress rejects it again.
This will allows all sides to claim they stuck to their positions, while avoiding a crisis. If there is no agreement, then the administration will have to choose which items not to pay and when.
This is no way to run a government and the US governance system is becoming dysfunctional.