“The dollar is our currency, but your problem.”

–Former Treasury Secretary John Connally

As the deadline nears for raising the US debt ceiling, the advocates of extend and pretend are attacking anyone and everyone who says that the federal debt ceiling should not be extended without extracting serious spending cuts. The Democrats in Congress see the proverbial writing on the wall, namely that 80 years of borrow and spend as the national ethic is about to end. Unfortunately neither the Democrats nor Republicans in Washington can see little else.

The fight over the budget is more than a fiscal debate, but also suggests the death knell of the two-party system in America. The socialist tendency we know as the Democratic Party is, to paraphrase President Ronald Reagan, the party of government. Prior to 1932, the Democratic Party was only marginally competitive in national politics. From FDR on through to today, the Democrats built their political fortunes on ever-increasing public spending and a corrupt relationship with the private and public sector unions.

Many Democratic political careers and institutions are now under attack in Washington as the Treasury is nearing the ends of its ability to borrow. Consider that current tax revenues just about cover transfer payments, where Washington taxes one American and subsidizes another. This leaves all of the other operations of government funded by debt. The reason for the conflict over the debt ceiling is obvious — except for members of the Democratic party and their surrogates in the big media.

“Bill Clinton was an Eisenhower Republican, but Obama is a more of a Nixon Republican, betraying core liberal beliefs on many issues,” notes economics writer and former Treasury official Bruce Bartlett, who sees President Barack Obama eventually cutting a spending deal with Republicans with less “smoke and mirrors” than President Clinton would never have accepted.

Back in April, we talked about why a delay in raising the debt ceiling is not the end of the world (see “Default, debt ceilings and democracy”). If it takes a financial crisis to change the fiscal behavior of the US, then so be it. You need courage to say no to more debt, but it is easy to borrow. The people of the US have the right and even the obligation to withhold approval of further debt issuance unless real changes are made in federal spending.

The Democratic party headed by Obama is making common cause with the large banks and corporations in the US to raise the debt ceiling without making significant cuts in federal spending. Big companies hate spending cuts, but don’t really worry about things like inflation. This quarter’s earnings is all that matters.

Ironically enough, the pro-democracy movement in American politics is now defended by the Republican Party, which finds itself almost forced to become more populist with each passing day. This is an uncomfortable position for established members of the GOP, many of whom are functionally indistinguishable from their Democratic peers on fiscal issues. With each election, though, the fiscally conservative tendency among conservatives is coming to dominate the Republican leadership. Even mainstream conservatives such as John Boehner cannot hold back more radical fiscal and social agendas of the GOP.

As the two institutional political parties wrestle over national spending, and paying attention only to each other, the US economy is entering a new and potentially dangerous period of deflation. The continued process of de-leveraging in the financial sector is causing banks to shrink and credit availability to dry up. And the government is about to make things a lot worse by allowing the conforming limit for loans sold by banks to federal housing agencies like Freddie Mac and Fannie Mae to fall dramatically.

After September 30, 2011, the maximum loan limit for single family homes in San Diego, CA, will fall from  $729,000 to $483,000 or to the pre-July 2007 levels. What this means is that the amount of mortgage financing available to markets all over the US is going to drop dramatically. While there are many markets where there will be little or no change, the markets most affected are also the areas where banks have the most exposure to future credit losses, the east and west coasts in particular.

“These housing markets are going to get clubbed to death like baby seals,” said one mortgage market veteran who assembled a list of the counties where the conforming loan limit is likely to drop the most.  The impact of this change is already being felt in real estate markets around the nation, especially in markets such as Washington, DC, New York, Los Angeles and Southern California. The maximum loan limit for Fairfax County, VA, dropped from $729,000 to just over $600,000.

The impending decrease in the conforming loan limit will accelerate the drop in home prices this year, adding fuel to the fires of deflation. Even as President Obama and the Democrats draw a line in the sand against spending cuts, the inattention of the White House to accelerating deflation in the housing market is creating a new crisis.

The Republicans welcome crisis as a means to destroy the Democrats as a national political force, but at what price?  The Democrats are resisting budget cuts, and in doing so only give the GOP the crisis that they seek. By the time the 2012 election cycle begins in earnest, for President Obama and both political parties, raising the debt ceiling will be the least of our problems.