I'll tell you first what I think won't happen: bond holders getting shorted for real. There might be some delays in payments, which is bad enough, but no actual cancellation. This is partly because constitutionally, there are issues, but mostly because 1) finance p0wns this government, and 2) if you do that, the US doesn't get downgraded from AAA to AA; it gets downgraded to something starting with a B.
"Who cares what S&P says? They haven't got a thing right in the last decade!" I hear you cry. Believe me, I know. But there are a lot of funds out there that can only - in some cases I believe by law - invest in AAA-rated investment tools. If the ratings agencies that matter drop the US's AAA rating, suddenly all those funds are out of US government bonds. And that's what people in the business call bad.
Another reason is because rates paid on money lent are affected by ratings - in no small part because of the above reason. Ratings go down, interest rates go up, suddenly your borrowing - if and when you finally get to do it again - gets a lot more expensive. I'm not willing to rule out that this isn't part of the plan; if the cuts-only crowd is pulling a Calhoun manoeuvre, then a great way to veto borrowing after you're dead and gone is to make it long-term more expensive.
Confidence has been shaken, no matter how this falls out. That's even if there's a deal, unless it makes substantial progress on deficit (note: deficit; not specifically size of government; this doesn't have to be cuts-only). We're already seeing collateral requirement hikes today for US bond holdings. Federal debt is becoming more expensive now.
I have heard the argument made that the US has already been effectively downgraded to AA in the markets; I think that's unlikely, because while it's deserved, most people are still considering all this just a kind of particularly aggressive posturing. The psychological effect of losing an A off the rating will be substantial; similarly to the effect on the passengers when Titanic started firing its flares; before that, people had been told abandon ship, but didn't really believe it. After the flares? Oh shit, this is real. And talking of real: somebody very, very large shorted about US$850M in T-bill futures today. Somebody large is betting large that the US is moving to a AA rating.
So all that is damage already done by this particular process. A deal that raises the debt limit without making meaningful deficit progress will make the above worse, but let's say that there's no extension of the debt ceiling for a few weeks. Negotiations are not going well, so - what happens?
I think things start more slowly than most people seem to expect. I don't think there will be the kind of in-your-face explosion I think a lot of people are talking about. Even now, it takes time for money - and information - to filter through the system, and paper changes take a lot longer to turn into real changes. Plus, there will be an assumption that they'll settle this thing in a few days - it won't drag on weeks. If that's wrong, look out; but that expectation will buffer the impact.
First, a lot of cheques stop coming. Exactly how that happens affects the specifics of the outcome. Assuming they're not mad enough to stop bondholder payments, my guess would be a combination of emergency service stops and across-the-board cuts. The US's FAA have already issued a bunch of STOP WORK orders at various construction projects at airports; this will be magnified across anything receiving Federal money, hitting employment and a lot of other aspects of the economy. Extended unemployment cheques are likely to take a huge hit or maybe just go away; honestly there's no telling. The cuts will be deep; the Tea Party hopes entire sections of government will be shut down. (C.f. HUD, Education, others.)
In other words, you'll have that 8.8% hit to GDP, and probably more. The effects on the private sector will magnify the effect, but if you're not getting Federal money, you won't feel it so quickly.
How this affects the banking sector - hoooooo boy. The banking system is still fundamentally insolvent. There has been substantial pretence towards the idea that all those worthless mortgage-backed CDOs actually have some value, and that's why the banks are alive - that, and holy crow US$16T in emergency loans, according to the Fed audit - but if money is withdrawn (and/or not re-extended), you could have a serious banking crash.
All this is true despite state-level retroactive immunity being granted over and over again for mortgage fraud (for chump change in fines), as well as Federal refusals to prosecute clearly documented and defined systemic fraud. As documented repeatedly, everything's fucked up, and nobody goes to jail. But we don't know, because we don't know how much liquidity is still in the system - ever since the Fed reclassified their loans as not-actually-loans, they don't have to report them.
The effect on the US$ will be mostly downward, across several apparently contradictory vectors at once. International traders did not like the opposing statements tonight and sent the USD downwards, but sentiment is already so negative that being oversold in the short term isn't out of the question. And the Euro is glad everyone else is looking over here, as Italy withdraws bond auctions because nobody wants them, and rates keep ticking up in general.
But regardless, with no bonds to buy, there will be less demand for the USD, which drives the dollar down against other currencies. Plus, the mere political failure will send people away from the USD, possibly chewing off whatever's left of its old "safe haven" shine.
At the same time, though, fewer dollars in circulation is strongly deflationary, so while imports would become more expensive, incomes would drop and the cost of borrowing (in real dollars) would rise. That means no pricing ability; goods may cost more, but nobody will pay, thus limiting inflation. Despite falling value vs. other currencies, it'll be a good time to have a lot of cash.
Sadly, all that will come just as US consumers have been kicking up credit card use for basic necessities, mostly thanks to stagnant and falling incomes in the face of sharply rising food and energy costs. Zero Hedge has a great, great chart on the non-recovery recovery that really illustrates a lot of what's gone wrong.
Now, what if they do something really stupid and stiff the bondholders?
That won't happen, because that ends the US dollar. Serious business ends it. At that point the debt ceiling does not fucking matter, because the currency is just done. If they stiff the bond holders, you'd want to hide in stock market index funds or something, because index funds and the like - anything indexed to actual value - will move up as the currency devalues. But, again, I don't think for a moment the government would do that; it's suicidal. (eta: And reports say that's just what the administration has been quietly telling banks.)
All this sounds like a disaster. And, really, it is. And that begs the question of, "Why would anyone do this?!" Well, there are reasons. We'll talk about them in Part IV.