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Short-term shutdown would pose little threat to national economy

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The U.S. economy is likely to take a brief government shutdown lasting a day or two in stride, but the longer it goes on, the harder it will hit.

Defense — the largest category of spending provided annually by Congress — would suffer the most, while consumers and state and local governments would begin to feel the pinch as most of the government bureaucracy and about 38 percent of government spending would be suspended.

The stock market has dropped in recent days as it became clear the government was heading toward at least a temporary shutdown. The Dow Jones industrial average fell 129 points Monday, its second straight day of triple-digit losses. But the markets have been blase about the possibility of any serious economic damage coming out of the now-familiar political impasse in Washington.

Investors, businesses and many American citizens have been lulled by their experience with previous standoffs in 2011 and 2012, when, after dire warnings and much-heated rhetoric, the parties reached a deal at the last minute that averted predicted doomsday scenarios.

Default worse than shutdown

The worst impact would come if the struggle between President Obama and congressional Republicans is prolonged through the middle of the month and is followed by a battle royale over raising the national debt ceiling, analysts say. That is when the economy could suffer a real gut punch and financial markets likely would react violently as fears rise that the U.S. is headed toward a first-ever default on its massive debts.

"A government shutdown would be temporary and probably make only modest dents in fourth-quarter growth, whereas failure to agree on raising the debt ceiling in a few weeks could put the U.S. in technical default and be massively disruptive to the economy and global financial system," said Russ Koesterich, chief investment strategist for BlackRock. He is telling his clients to buckle their seat belts and get ready for a rough ride,

Vincent Reinhart, chief economist at Morgan Stanley, estimates that each week the government is shut down will trim annual economic growth by 0.15 percentage points.

"The odds favor a short event — over within one week," calling that a "low-impact collision" for the economy, he said.

While a shutdown lasting a few days will slow the economy, a prolonged failure of the two parties to come to terms over the role of government could have more lasting effects on consumer and business confidence and planning, and be an ominous portent of what could happen later this month when the government's bills come due, said David Kelly, chief global strategist at JP Morgan Funds.

"It does not bode well for the next fight in just a few weeks, where the far more dangerous hostage of the debt ceiling will be placed at the center of the circular Washington firing squad," he said.

Boehner behind the scenes?

Joseph Lake, a U.S. analyst for The Economist Intelligence Unit, said he is hopeful that the strategy of House Speaker John A. Boehner, Ohio Republican, was to tie the GOP's bid to delay Obamacare, the president's health care reform law, to the government funding measure because he knows the economic impact from a temporary shutdown while the parties duke it out will be far more limited than that from a lapse of the $16.7 trillion debt limit later this month.

"The most optimistic reading of the current situation is that [the Ohio Republican] has, in effect, turned the budget talks into a referendum on Obamacare, because he realizes that to do so with the debt ceiling would be willfully irresponsible," he said. "The more pessimistic take is that the first government shutdown in 17 years will embolden rank-and-file Republicans in the House to act just as recklessly when they are required to raise the government debt ceiling," precipitating a real economic crisis.

Mr. Lake expects Republican allies in the business community, who are nearly unanimously calling for a timely increase in the debt limit, to prevail upon House Republicans to act before the Oct. 17 deadline when the Treasury says it will run out of borrowing authority and have only $30 billion in cash to pay daily bills that reach as high as $60 billion.

Paying the bills

In a note to investors Monday, Moody's Investors Service noted that one of the reasons a short shutdown is not too threatening for the economy is the Treasury is able to keep paying the interest on the national debt and to keep sending checks to people who derive most of their income from Social Security, Medicare, Medicaid, veterans and other government entitlement programs.

Once the Treasury exhausts its borrowing authority in mid-October, however, it might have to stop paying some entitlements, and it could eventually run short of the cash needed to make interest payments on the debt, forcing it into default, said Moody's, which has maintained its AAA rating on the U.S. debt despite the impasse.

"Failure to raise the debt limit would be worse than a shutdown," and have potentially severe consequences for the economy and financial markets, said Moody's Senior Vice President Steven Hess.

Moody's calculates that the Treasury would have to immediately cut spending by 15 percent to 20 percent across the board Oct. 17 — "an amount likely to drag on the economy," especially if it comes on top of a prolonged shutdown, Mr. Hess said.

Despite such a damaging scenario, Moody's remains largely unruffled and has not issued a warning to bond investors because "we believe the government would continue to pay interest on Treasury securities," at least up until mid-November, even if the debt limit does lapse, he said.

Treasury would be forced to make "painful choices" about cutting other programs, but October interest payments are relatively small and easily could be paid out of revenues that come in each day, he said. But on Nov. 15, a large $16 billion interest payment comes due that could become a breaking point that forces the Treasury into default, he said.

On top of the sequesters

Defense, transportation, housing and other parts of the government due to lose their funding and shut down at midnight Monday already have been scrambling to carry out $85 billion in budget cuts this year — a trim that would continue even if the House-drafted funding bill eventually is enacted.

Thus, the shutdown deals a second blow to the strapped discretionary part of government, and the thousands of contractors, state and local governments that depend on it.

Moody's said certain big contractors that are heavily wed to defense spending are vulnerable during a shutdown, including Lockheed Martin Corp., Alliant Techsystems Inc., and Booz Allen Hamilton, while other large contractors that are more diversified will fare better, including Honeywell International, Boeing Co., and Rockwell Collins Inc.

If the shutdown leads to a lapse of borrowing authority, health care insurers, hospitals and doctors who treat Medicaid and Medicare payments also would feel the impact. Because state and local governments often act as funding transfer agents for those health care programs, as well as education and other social programs, they also would be hit hard by a prolonged shutdown of government spending and borrowing authority.

Consumers also will be irked and inconvenienced by the closure of national parks, passport offices and thousands of other government services during the spending hiatus. Areas with a big government presence and many contractors, such as Washington, D.C., will be affected most, Moody's said.

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