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First things first, what is the debt ceiling anyway?

The debt ceiling is exactly what its name implies – the maximum debt the U.S. is allowed to build up. When the U.S. can’t adequately fund its spending plans with its tax revenues, it’s often forced to borrow money. To make sure that the Treasury doesn’t go overboard and drown the U.S. in debt, the Congress sets a debt ceiling to control how much it can borrow.

Right now, the debt ceiling stands at 14.3 trillion USD, which is already ginormous by all measures. Yet many are calling for the U.S. to raise it even more. How come?

The problem is that the U.S. is already dangerously close to bumping its head and hitting its debt ceiling. Treasury Secretary Timothy Geithner says that unless the U.S. lifts the ceiling by August 2, 2011, poop will hit the fan. However, policymakers are still divided on the matter of how they should “raise the roof.”

Democrats want spending cuts AND tax hikes to help temper U.S. debt in the event the government decides to increase its debt limit. On the other hand, Republicans want to rely purely on spending cuts and want nothing to do with tax increases. Ayayay! Leave it to the leaders of the world’s largest economy to bicker like little girls.

Economic gurus are already getting frustrated with the ongoing debate. Some analysts argue that if the Congress doesn’t raise the debt ceiling on time, the government could default on its debt. Yikes!

Geithner says that we would see the most significant impact on investor confidence if the Congress fails to act before the August deadline. The 6-point increase in credit default swaps spreads on U.S. bonds over the past couple of months is interpreted by many as a sign that investors are demanding higher interest rates to hedge for the possibility that the U.S. may not be able to pay bondholders. Uh oh…

But don’t worry, just yet! You should know that there are a handful of economic gurus who do not share this view. Yes, the Treasury will have to prioritize its spending but debt and interest payments would probably be at the top of its list. Probably.

Another problem would be the massive cutback in spending. If the debt ceiling isn’t raised, it would only be a matter of weeks (or even days!) before certain Social Security and Medicare benefits would be suspended. The government may even send a handful of employees to the jobless claims queue. Consequently, with the prospect of more Americans losing confidence and jobs, some naysayers think that the economy could dip back into recession!

With all these scenarios painting a gloomy fundamental landscape for the dollar, I wouldn’t be surprised to see the currency head down south as concerns about the debt ceiling gain steam. Perhaps we may even see the U.S. Dollar index trade back down to its previous low at 73.50. After all, a few market junkies are already saying that the recent dollar weakness is due in part to the heated debates in Washington.

USDX Daily Chart

So I guess all that’s left to do now is wait and cross our fingers for U.S. policymakers to come to an agreement to raise the debt ceiling. What do you think? Should the Congress raise it now or delay it a little longer to foster fiscal discipline?