By Tim Reid and Steven C. Johnson
WASHINGTON/NEW YORK (Reuters) - An idea once confined to the fringe of the Republican party is seeping into its mainstream -- that a brief default might be an acceptable price to pay if it forces the White House to deal with runaway spending.
An increasing number of Republicans do not believe the Obama administration's dire predictions of economic "catastrophe" if the debt limit is not increased. They argue a period of technical default can be managed without plunging markets into chaos.
Establishment Republicans including Tim Pawlenty, the former Minnesota governor who announced his presidential candidacy last month, are backing a short-term default if it leads to deep, immediate spending cuts.
Jeff Sessions and Paul Ryan, the top Republicans on the Senate and House Budget Committees, have also said failure to raise the debt limit would not trigger immediate catastrophe.
Republican Senator Pat Toomey has even introduced legislation directing the Treasury to prioritize debt service over other payments if the debt limit is not raised. It has 22 Republican co-sponsors in the Senate and 98 in the House of Representatives, although no members of the Republican leadership have backed it.
David Frum, a former speechwriter for President George W. Bush and a Republican advocate for raising the debt limit, said he holds regular question-and-answer sessions with Republican congressman over a beer.
"I have yet to meet one Republican who actually says a failure to raise the debt limit scares them," Frum said. "It is deeply, deeply troubling the number of Republicans I now talk to -- and I include the mainstream -- who think a technical default is manageable.
Many on Wall Street disagree. They fear even the briefest default would cause a steep climb in interest rates worldwide and a tumbling dollar, which would tip a fragile economy back into recession and cause financial market upheaval on a scale not seen since the collapse of Lehman Bros.
Fueling skepticism over this outcome is an argument made last month by legendary investor Stan Druckenmiller, a one-time ally of George Soros, who said he would favor a short-term default if in exchange lawmakers in Washington struck a deal for massive spending cuts and a medium-term plan to tackle the $1.4 trillion deficit.
"That had a lot of impact on Republicans," said Vin Weber, a veteran Republican strategist and party moderate. He said the idea that a short-term default would not be a problem "is definitely becoming a mainstream belief."
While Druckenmiller's hardball approach may resonate with Republicans in Washington, it has few fans on Wall Street.
Ratings agency Moody's warned on June 2 it would consider cutting the United States' top-notch credit rating if it did not see by mid July substantial progress toward an agreement between the White House and Congress to increase America's $14.3 trillion borrowing limit.
Moody's lead credit analyst for the United States, Steven Hess, said on Tuesday the agency would not immediately downgrade Washington's Triple-A credit if it missed the August 2 deadline. It would wait to see if interest payments were made.
Bond investors say even a temporary default could erode confidence in Treasuries and the dollar, wreak havoc in mutual funds and possibly provoke another global crisis.
"It's a very dangerous tactic," said Mirko Mikelic, who helps manage $17 billion at Fifth Third Asset Management. "I think you would see investors move away from the United States and move to other markets as they lose confidence in the financial system and our ability to keep our house in order."
Many Republicans doubt the August 2 deadline. They argue that if the borrowing cap is not raised by then, the Treasury will have sufficient revenues to service the nation's interest payments and, for a period of time, pay obligations such as Social Security and Medicare.
More mainstream skepticism could hamper efforts by Vice-President Joe Biden to hammer out a deal on raising the borrowing cap with a bipartisan group of lawmakers, which meets for a sixth time on Thursday.
The two Republicans in those talks, Senator John Kyl and Eric Cantor, part of the House leadership, have warned Biden that they do not have total control over their caucus -- and that without massive spending cuts a deal cannot be reached.
A Democratic member of the talks said the threat of growing Republican opposition to a debt ceiling rise was a clear negotiating tactic. Yet he did not doubt the growing skepticism across the aisle was real.
Pawlenty has said the government should put debt interest payments ahead of other federal spending, an approach that would allow the government to prioritize obligations while a deal to dramatically cut spending is negotiated.
Ryan said last month that holders of government debt would be willing to miss payments "for a day or two or three or four" if it put the United States in a stronger position to pay them later on, and if investors knew that.
"That's what I'm hearing from most people," Ryan, the author of the House Republicans' budget plan, told CNBC. Sessions says the Obama administration's August 2 deadline is a "scare" tactic that has backfired.
FEARS OF CHAOS
Treasury Secretary Timothy Geithner says failure to increase the debt limit by August 2 will lead to a crisis in the markets that could plunge the back into recession.
Priya Misra, head of rates research at Bank of America-Merrill Lynch, said $25.6 billion in Treasury interest payments due on August 15 could be in jeopardy if the August 2 deadline is not met.
If the United States defaults, money market mutual funds that invest in short-term government bills, considered one of the most secure investments, could "break the buck" by falling below $1 a share, Misra said.
The resulting losses could spark a bank run of the sort seen when Lehman Brothers collapsed in 2008.
Frum criticized Republican leaders for not sounding the alarm. "The real question is: who among the Republican leadership is saying 'you can't do this?' Frum said. "The leadership has not issued serious warnings to their own members."
John Boehner, the top Republican in the House, is trying to placate two audiences: Wall Street and his own restive caucus.
He said on June 1 that "nobody out there believes the is going to default on its debt." Yet he also says he understands "doubts" his own members have about raising it.
Jim Nussle, a former White House budget director under George W. Bush, has joined the default skeptics. "The worse that would happen is some form of rolling government shutdown, rather than a default," he said. "No-one's going to default."
Robert Tipp, chief investment officer at Prudential Fixed Income in Newark, says the yield on the 10-year Treasury note, now around an historically low 3 percent, could quickly jump 40 to 50 basis points if the debt ceiling is breached.
The impact on the dollar could be even greater, especially if ratings agencies cut America's credit rating.
"Foreigners don't buy Treasuries for the yield but for the safe-haven status," said Citigroup currency strategist Steven Englander. "If you do your best to blow up that safe-haven status, they won't want the dollar exposure. Their patience is not infinite."
"It would be a whole new world where people would be less inclined to purchase our debt, finance our deficits, it would definitely be a game changer globally," said Fifth Third's Mikelic.
(Additional reporting by Andy Sullivan, Karen Brettell, Richard Leong, Ellen Freilich, David Gaffen and Daniel Bass; Editing by Kristin Roberts, Stella Dawson and Sandra Maler)