Happy Halloween… On the 4th of July?

Well, here we are with less than a month to go before government debt hits the statutory limit around the middle of May. To be sure, the Treasury can postpone the fateful day until some time in early July by using its intragovernmental accounts and other extraordinary mechanisms to keep the debt below the official limit. Still, doomsday isn’t far off. Imagine celebrating the 4th of July on the very brink of bankruptcy.

Markets are understandably nervous. Standard and Poors has issued a warning; Pimco, a large bond fund, is selling its Treasuries; and the rates investors are willing to pay on the financial instruments used to insure against default are rising.

Will we default or breach the limit? No. We still have revenues that can cover 60 percent of all spending, including interest on our debt, although which spending would be protected isn’t entirely clear. And with no new debt in the cards, we could use maturing debt to offset any newly issued government paper. Of course, cutting spending or raising taxes by 40 percent for very long would not only be draconian but politically beyond the pale.

The interesting question is can the two parties in Congress make a deal to raise the limit in the face of Republican demands for sharp cuts in spending and the administration’s preference for a clean unconditional agreement to do the “right thing” for the country. The administration should point out that honoring one’s debts is the issue here, not current spending and tax policy. These debts reflect past decisions made by both Republican and Democratic administrations. Using the debt ceiling as a way to blackmail a Democratic President into cutting spending in draconian ways in the middle of a very weak recovery is a really bad idea.

One possibility is that both parties will kick the can down the road by agreeing to a trigger mechanism that produces automatic debt reduction if the debt to GDP ratio fails to stabilize after a certain point such as 2014. The President proposed something like this in his latest plan but with the automatically-triggered debt reduction accomplished on both the spending and tax side of the budget. Republicans, who with few exceptions, are not willing to contemplate tax increases of any kind will probably counter with a spending-only trigger. Compromise might lead to a trigger heavily weighted toward spending but with a minor role for taxes in the package and exemptions for Social Security, Medicare, and programs for the poor.

Another possibility is a temporary lifting of the debt ceiling to give both parties more time to negotiate, building perhaps on the work being done in the Senate by a bipartisan group of six.

In the meantime, how financial markets react to all of this squabbling and the resulting stalemate remains to be seen. But we could see a fourth of July that looks more like Halloween.

Happy Halloween, everyone.