A chorus of global banks has warned that Washington risks triggering a global slump and may suffer permanent loss of credibility by flirting with default on America's $14.3 trillion (£8.8 trillion) federal debt.
The dangers are almost as great if the US fails to lift the debt ceiling and avoids default by enacting the most drastic fiscal squeeze in modern history.
"Default would be an act of collective insanity," said Willem Buiter, Cititgroup's chief economist. "Even if a default were cured promptly, it would severely dent the credibility of the US as a global financial player and the provider of the world's leading reserve currency. There would be an immediate repricing of the dollar and an increase in medium and long-term nominal and real interest rates. Asset, credit, and funding markets in the US and the world as a whole would likely suffer and a global recession would likely result, centred in the US, but not restricted to it."
Mr Buiter said brinkmanship on the US debt ceiling had reached a point where tail risk had "morphed" into a serious possibility, with a 5pc likelihood that Washington will pull the trigger on a technical default.
Stephen Roach, head of Morgan Stanley in Asia, said Chinese officials are disgusted by the "astonishing recklessness" of Washington as default looms. "Coming so shortly on the heels of the sub-prime crisis, the debate over the debt ceiling and the budget deficit and is the last straw," he said.
Andrew Garthwaite from Credit Suisse said a default would be catastrophic, causing 5pc contraction in the US economy and a 30pc drop on Wall Street, with "massive" ramifications for the world."It is almost unthinkable to believe the US would miss a coupon payment [$29bn are due on August 15]. If the US does default, the repo market would probably cease to work. It is hard to imagine money market funds operating under this scenario. The inter-bank market would freeze up. The fallout would be far worse than after Lehman's default," he said. "It would be horrible to think what happens to the dollar if the Fed hints it would offset the growth damage with QE3."
Mr Garthwaite said it might not be that much better if the US fails to lift the debt ceiling and enacts a draconian fiscal squeeze equal to 11pc of GDP (annualised) to stave off default.
Such an outcome would at first lead to a 10pc to 15pc drop in equities and a fall in 10-year Treasury yields to 2.75pc. The dollar would slide. The longer it went on, the worse it would be. Each month would mean fiscal tightening equal to 0.9pc of GDP.
Some experts fear that variants of this scenario would spiral out of control. It would drive a string of US states and municipalities into bankruptcy if it lasted more than a few weeks, while the multiplier effect would tip the economy into a self-defeating downward spiral with echoes of 1931.
The US Treasury will announce its emergency plans if there is no deal on the debt ceiling by Thursday night. The government is already stepping up contingency planning and is working on a scheme for how it will operate without borrowing authority. Some on Wall Street believe that because of better-than-expected tax receipts in July, the Treasury has enough money to meet all its bills for at least a week after Tuesday's deadline.
Fathom Consulting said the twin debt crises in the US and Europe risk feeding on each other in a dangerous synergy unless leaders get a grip quickly. "We are on the brink of a major sovereign debt crisis: the latest European bail-out package has done next to nothing to alter that view," said the group.
Fathom said the Washington stalemate risks pushing up yields on US Treasuries, lifting the global benchmark cost of money known as the "risk-free rate" with knock-on effects in Europe.
Eurozone borrowing would rise in lockstep, playing havoc with debt dynamics. Fathom said failure to reach a US deal could drive up yields on 10-year Treasuries by 300 basis points to 6pc by next year. "Ultimately, this could tip the euro into default."
"Such a rise in the 'risk-free' rate would reverberate across the world and across asset classes. It could push both peripheral and core European bonds into default territory. It would almost certainly lead to a renewed global recession and banking crisis - only this time there would be only one country left to absorb the losses - China," it said.
China is clearly not large enough to carry such a burden and is itself trying to navigate a "soft-landing" from its credit boom. The HSBC manufacturing index for China has tipped below the contraction line of 50.
Citigroup said the most likely outcome (60pc chance) of the Washington drama is a rise in the debt ceiling with a small fiscal package below $2 trillion that makes "no material difference" to the US debt trajectory and fails to satisfy rating agencies. This will lead to a downgrade from AAA to AA "initially".
The damage to confidence would stifle growth for the next two quarters and open the way to fresh Fed stimulus early next year.
Mr Buiter said the chances of a "rosy scenario" where the debt ceiling is lifted, the US implements a credible bipartisan package, and there is no US downgrade, is a miniscule 1pc.
Credit Suisse sees a 50-50 chance of a US downgrade even if the debt ceiling is raised, but doubts that this would have "much effect" since regulators would not force AAA funds to sell their debt holdings.
Credit Suisse said that if the US defaults then the best safe havens are companies such as Pearson, Compass, Centrica, Basf, Siemens and Sanofi, all deemed by markets to be safer than G7 average sovereign debt, based on credit default swap prices. Switzerland's Novartis trades at 34 basis points, below the CDS of the US, Japan, Britain, France or Germany.
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