US would pay bondholders after Aug 2: Bernanke

If the United States fails to raise the debt ceiling by Aug. 2, it will pay creditors first and stop benefits like Social Security payments, Federal Reserve Chairman Ben Bernanke said on Wednesday.

The central banker's comments offered the first public indication of how the Obama administration will prioritize its financial obligations after Aug. 2, when the US Treasury says the government would run out of money to pay all of its bills.

"The assumption is that as long as possible, the Treasury would want to try to make payments on the principal and interest to the government debt, because failure to do that would certainly throw the financial system into enormous disarray and have major impacts on the global economy," Bernanke said.

His comments will reassure many investors, but threatening Social Security is dangerous politics ahead of 2012 elections.

Even though the expectation is for Washington to prioritize its debts, the Obama administration has so far refused to talk about planning for a possible default because it wants to avoid giving Republicans a reason to see Aug. 2 as a soft deadline.

President Barack Obama and congressional leaders are due to meet for a fourth straight day at 4 p.m. EDT (2000 GMT) in an effort to reach a deficit reduction deal that would clear the way for Congress to increase the USD 14.3 trillion debt ceiling.

While both sides agree on the need to increase the debt limit, they are still far apart on how to do it. Talks have become more acrimonious in the last few days as Republican and Democratic leaders have lashed out at each other and hardened their positions, making compromise difficult.

Bernanke's comments could further complicate talks because they could be used by conservatives to bolster their claim that default can be avoided by paying bondholders first, something Treasury Secretary Timothy Geithner says is unworkable.

Republicans have insisted on steep spending cuts in return for voting to increase the debt ceiling. But both sides are divided over tax increases, which Democrats insist must also be part of any long-term budget deal. Republicans say they won't back any tax hikes because they could hurt the economy.

House of Representatives Republican leader Eric Cantor, who has been at odds with House Speaker John Boehner, the top Republican in Congress, over how to reach agreement, said the two sides should focus on the roughly $3 trillion in spending cuts that had been floated as part of a "grand bargain" that Obama had proposed.

Democrats are not likely to back that idea because it would require deep cuts to benefits programs that they oppose and would not include the $1 trillion in tax increases they seek.

Investors so far are more concerned about a mounting debt crisis in Europe than a possible default in the United States, analysts said. Demand remained strong on Wednesday for 10-year US Treasury notes, with yields near their lowest mark since December.

Not taking sides

Bernanke said he was reluctant to take sides in the deficit reduction debate but made clear that prioritizing the debt would hurt ordinary Americans.

"As a matter of arithmetic, fairly soon after that date there would have to be significant cuts in Social Security, Medicare, military pay or some combination of those in order to avoid borrowing more money," Bernanke said, focusing on areas affecting the elderly and the military that could affect key voting blocs ahead of 2012.

Missing the Aug. 2 deadline would force an immediate 40 percent cut in government spending, he said.

The chairman of the central bank is not a member of the administration, but the Federal Reserve has been involved in the Treasury Department's discussions on how to prepare for a possible default.

Obama issued a similar warning on Tuesday, saying he could not guarantee that Social Security pension checks would go out on time in August if no deal was reached.

Asked in a new Reuters/Ipsos poll what bills the government should stop paying if the debt limit is not raised, 36 percent of Americans listed international creditors like banks.

Bernanke also echoed the oft-repeated warning of a global financial crisis if the United States defaulted on its debt.

"It's the foundation for much of our financial system and the notion that it would become suddenly unreliable and illiquid would throw shockwaves through the entire global financial system," he said.

Not everyone on Wall Street saw his statements on prioritizing U.S. debt in a positive light.

"If they're literally scrambling over a weekend to avoid a technical default by making selective payments I'm not sure that's really a solution," said Christian Cooper, head of dollar derivatives trading, Jefferies & Co, New York.

"The markets would broadly perceive that as a failure of leadership and a fiscal failure, because the markets would perceive that we have a complete failure of leadership."

Several conservative House Republicans, however, questioned whether financial markets would be affected by a default as long as the government continued to make its bond payments.

They proposed a bill that would require the Treasury Department to prioritize military salaries, along with bond payments, over other forms of government spending in the event the debt ceiling is not raised.