|Barack Obama has to make an agreement with Republicans to avoid a payment default on the US debt [REUTERS]
Barack Obama and Republican leaders in the House of Representatives are deadlocked over how to raise the US debt ceiling.
As the deadline of August 2 fast approaches, the IMF has warned of a "severe shock" to the world economy if the US runs out of cash to pay its bills.
What is the debt ceiling?
The debt ceiling is the legal limit on the amount of money the US government can borrow to pay its bills, which includes the salaries of federal employees, federal programs such as Social Security and Medicare (a health insurance program for the elderly), and principal and interest payments to bondholders. The current limit is $14.3tn.
What has gone wrong this time?
The US constitution stipulates that only Congress can authorize the federal government to borrow money. Since 1962 Congress has raised the debt ceiling 72 separate times, including 10 times in the past decade alone.
A rule adopted in 1979 had allowed the House of Representatives to automatically raise the debt limit to whatever level the budget required. But in January 2011, the House voted to repeal this rule, requiring the House to hold a separate vote to increase the debt limit.
When Obama took office in January 2009 in the midst of the biggest economic turndown since the Great Depression, US public debt stood at $10.6tn. This May, two and a half years later, the current debt limit of $14.3tn was reached. The US Treasury can extend the August 2 deadline by exploiting various loopholes, such as postponing pension payments to federal employees.
Most analysts say that even after August 2, the Obama administration has some flexibility to continue meeting their payments at least for a few more days. Federal Reserve chairman Ben Bernanke has said that after August 2, the Treasury will prioritize payments on federal debt.
Republicans, who currently control the House of Representatives, want to reduce the national debt by cutting government spending. Some Democrats are calling for a mix of tax increases as well as spending cuts. The latest Democratic plan contains no tax increases, but Republicans argue that it does not cut spending enough.
Most (though not all) legislators agree that a deal needs to be reached to avert catastrophe. The question is how this deal will be structured.
Why is US debt so large?
In the wake of the financial crisis of 2008, government spending soared when bailout and stimulus bills were passed in efforts to rescue and reinvigorate the US economy. Meanwhile, the recession caused tax revenues to slump. With less revenue and more expenses, the deficit grew. To meet these shortfalls, the US government borrowed more money, adding to the national debt.
The problem goes back further, though. In 2001 and 2003 George W. Bush signed into law tax bills that lowered the top marginal income tax rate from 39.6 per cent to 35 per cent, and slashed the top capital gains tax rate from 20 per cent to 15 per cent. As a result, according to a USA Today analysis, the percentage of income that Americans are paying in taxes is at its lowest level since 1950.
Meanwhile, the wars in Afghanistan and Iraq swelled the deficit. Health care is another big cost: The amount that the US government spent annually on Medicare increased by 137 per cent from 1999 to 2009. According to the US treasury, the national debt has risen by more than $500bn each year since 2002.
Can't the US treasury just borrow more money?
Only the US Congress is constitutionally allowed to raise or lower the limit of the debt ceiling. So any decision will have to be approved by Congress; the US Treasury can't act alone.
All government spending commitments and tax-raising powers are checked, scrutinised and agreed upon by Congress. This is part of a constitutional arrangement created by the founding fathers of the US to ensure checks and balances between the legislative and executive bodies are in place, so that neither body will be able to abuse its power.
Can both sides agree?
In the latest round of talks, President Obama proposed a plan to cut spending by $3tn and raise taxes by about $1tn over the next ten years.
The Republicans want more tax cuts, but have agreed to impose cuts on military spending, and have offered to increase tax revenues by removing some loopholes.
For his part, Obama had agreed to limit the way Social Security payments are indexed to the inflation rate, and to raise the age at which Americans become eligible for Medicare from 65 to 67.
But John Boehner, the top Republican in the US House of Representatives, has refused to accept any deal that raises tax rates.
"The American people will not accept an increase in the debt without significant spending cuts and reform," Boehner warned. President Obama, Boehner said, "has often said we need a 'balanced' approach - which in Washington means: we spend more, you pay more ... those tax increases will destroy jobs".
Obama has called for a compromise package that would make deep cuts in entitlement programs to slash spending, which Republicans want, and an increase in revenue by raising taxes on high-income earners - a move that Republicans passionately reject.
"How can we ask a student to pay more for college before we ask hedge fund managers to stop paying taxes at a lower rate than their secretaries?" Obama asked.
What are the options available?
The first option is capitulation: President Obama could meet the concessions demanded by the Republicans and agree to bigger spending cuts, tax breaks for high earners and a partial repeal of his healthcare reforms.
But the president rejected a Republican proposal to temporarily lift the debt limit, arguing that it would leave the underlying problem unresolved and lead to a repeat of the current crisis in six months.
"That is no way to run the greatest country on Earth. It is a dangerous game we've never played before, and we can't afford to play it now. Not when the jobs and livelihoods of so many families are at stake," he said.
The second option is to buy time and take the offer of a reprieve in payments for up to six months, which means a new deadline in the run-up to the 2012 Presidential elections.
What happens if no deal is reached?
US treasury secretary Timothy Geithner says that if the US ends up defaulting for the first time in modern history, the effect will be "catastrophic."
The rates on US treasury bonds would spike, making it more expensive for the US to borrow money in the future. And since US bond yields serve as a floor for other lending rates, local governments and US corporations would find it more expensive to borrow money, and Americans would have to pay more to service their mortgages.
But since the US is the world's biggest economy, the implications of a default could be equally grave in international markets. Because the global money market - a short-term loan market used by businesses around the world to finance their operations - often requires assets to be backed by US treasury instruments, a US bond default could cause this market to freeze up, as it did in September 2008 when Lehman Brothers collapsed.
Finally, the US dollar would almost certainly decline in value.
So far, the US economy has not seen any significant increase in its borrowing cost; at the moment, yields on ten-year Treasury bonds are hovering at around 3 per cent. This is in sharp contrast to Greece and other indebted eurozone governments. Their bond yields soared, crippling their economies and requiring a bailout.
The major rating agencies are somewhat less relaxed. On July 15, Standard & Poor's warned that it could cut the US' coveted AAA credit rating if no deal is done, which could limit some investors' ability - and willingness - to lend to the US government. Even if the US does continue to pay bondholders, if investors refuse to buy US bonds, that could cause panic on the markets, forcing a default.
Can the Republicans and Obama come to an agreement?
In the latest round of bargaining, Republicans in the House of Representatives submitted a proposal mandating $1.2tn in budget cuts over the next ten years and placing caps on future spending. The plan would raise the debt ceiling by about $1tn, which would mean that Congress would have to approve another debt ceiling increase before the 2012 presidential elections.
In recent days, Republicans have also demanded that any vote to raise the debt ceiling be coupled with abolishing the individual mandate to purchase health insurance, the centerpiece of Barack Obama's health-care plan. The plan does not include any tax increases.
Democratic Senate majority leader Harry Reid countered with a plan to cut $2.7tn over the course of the next ten years - far more than even Republicans had initially proposed. The $2.7tn figure counts $1tn in savings from the drawdown of the wars in Afghanistan and Iraq. Another $1.2tn would be cut from federal agency budgets. In a major concession to Republicans, the Democrats' plan also includes no tax increases.
At the moment, neither side has agreed to support the other's plan. Boehner says that Reid's plan is "full of gimmicks" because it does not deal with entitlement programs such as Social Security and Medicare. Meanwhile, Democratic Senate Majority leader Harry Reid said the Republican plan was a "nonstarter".
And the political will may not exist to pass a deal before August 2. Many Republicans have argued that a short-term default would not create serious problems. According to Reuters, former Minnesota governor Tim Pawlenty, a presidential candidate, supports a default if it would result in deep spending cuts.
Senator Jeff Sessions, the top Republican on the Senate budget committee, and his counterpart in the House, Paul Ryan, have said that a brief default would not be a catastrophe. If enough House Republican members view default in this way, it may be difficult for Boehner to get his caucus to support any deal.
How would a budget deal affect the US economy?
At this point, it seems highly unlikely that any budget deal will include substantial tax revenue increases. Instead, spending cuts will comprise a much larger part of a deal.
The US economy remains anemic, with unemployment hovering above nine per cent. Although the US stock market has recovered strongly since its nadir in March 2009, wages have not risen, and consumer spending remains weak.
A sharp cut in US government spending would probably have counter-stimulative effects on the economy, creating the risk that the US economy would plunge into a so-called "double-dip recession".