Some brief thoughts:
First, the lack of a agreement/deal right now does not mean too much. There have been some negotiations, but there have also been periods of recess (Easter/Passover and Memorial Day) for Members of Congress. The more aggressive effort to find agreement will probably begin when Congress returns from the Memorial Day recess.
Second, ideally, the debt ceiling would be increased with some kind of credible fiscal consolidation. Odds of that combination are fairly low: lack of support from the American people for the kind of difficult decisions required, complexity of the issues at hand, political differences, etc. It should also be noted that a large part of the debt ceiling increase is necessary on account of policy that has already been enacted e.g., the mandatory spending programs are running on autopilot.
Third, I expect that a deal will be reached. The debt ceiling will probably be increased by $1.5 trillion to $2 trillion. Modest spending cuts would be agreed and implemented for FY 2012. In terms of the larger structural issues, some kind of finessing will occur. Goals or targets would probably be adopted, but the policy specifics would need to be defined later. Such an arrangement would allow the Republicans to assert that spending reductions were made and commitments for more aggressive spending reductions/mandatory spending reforms are in place, and that the combination of spending reductions matches or exceeds the amount by which the debt ceiling was increased. It will also allow them to assert that no tax hikes were agreed. At the same time, the Democrats will be able to assert that tax hikes have not been removed from the table and that a broader examination of mandatory spending reforms could occur before final decisions are made.
Less likely, but not completely out-of-the-question, would be a deal that raises the debt ceiling by a modest amount (perhaps sufficient to buy 6-12 months of time) in exchange for modest FY 2012 spending reductions and a second increase for the remainder of the request being approved or even occurring automatically once legislation to implement the larger goals/targets has been adopted. That move would alleviate any immediate risk of default or draconian spending rationing, while buying time for the Congress to carefully work out a deal on the larger issues. Of course, with the 2012 election approaching, such a move would probably not be optimal from a political calendar standpoint. Hence, it might be a last resort if the above approach is not agreed.
I suspect that many Republicans, who are caught between the need to compromise in reaching a deal and certain elements from the Tea Party who are insisting on an uncompromising stance, will take the former approach. Republicans have more to lose this time around. A short default coupled by only modest fiscal consolidation would undermine their credibility and leave them with the consequences of the default. A long default would damage their standing regardless of the fiscal consolidation that would follow given that the risk premia might well have made an already difficult fiscal challenge far greater than it would otherwise have been. Only a short default followed by substantial fiscal consolidation might benefit them. Not surprisingly, Mr. Druckenmiller's comments on a several days' delay in the Treasury's making debt service payments are being touted by some senior Republicans e.g., Congressman Ryan--perhaps in a testing of possible reaction to such a move. IMO, the political risks associated with default and its consequences are too great to allow such a move. Hence, I expect that compromise is far more likely than not, even if certain Tea Party elements threaten to push for contested primaries.
Democrats will also do the Republicans no favors, as they perceive Republican stumbles in the high-risk situation concerning the debt ceiling issue as perhaps creating an opening for the 2012 elections. They will likely assert and reassert a readiness to raise the debt ceiling and avoid the risk of default/severe spending rationing to avoid default. They will not be inclined to "rescue" the Repbulicans from Tea Party elements who either are uncompromising (some elements want no debt ceiling increase under any circumstances) or seek such enormous immediate changes that those changes are far beyond what the U.S. public (still behind the curve on the fiscal consolidation issue) and broad majority of policy makers would support, especially if the Democrats view such changes as 'political suicide.'
Fourth, this arrangement would amount to a sort of "punt" with the larger required structural changes likely being postponed until after the 2012 elections when the new political landscape is more evident. Such a move might also buy time for policy makers to educate and inform the public on the big choices/tradeoffs that will have to be made. What is necessary will be agreed (debt ceiling increase). What is possible will be part of the agreement. What would be desirable (necessary for the medium-term and beyond) will likely be postponed.
Fifth, rhetoric that bondholders would accept a short default is pure speculation. Some e.g, Mr. Druckenmiller, have stated that they would. But it remains unclear how the overall markets would respond, especially as the U.S. would be on virgin territory so to speak with respect to its debt-related track record. I suspect that once a default, even a short one, took place, the markets would calculate that the level of inhibition for such moves would be lower. Hence, there would be some long-term risk premium that would follow. How large that premium would be would depend on many factors.
Sixth, another thing to watch for is how the Fed responds should inflation persist. One cannot rule out the Fed's tolerating moderate inflation, allowing inflation to ease the debt burden e.g., by holding sufficiently low interest rates so as to result in negative real interest rates. That kind of "financial repression" has occurred in numerous countries in the past as a means of trying to avoid default.
