* Two sides are still deadlocked
* Lew says Congress is "playing with fire"
* Conflict could go down to wire
By Richard Cowan
WASHINGTON, Oct 7 (Reuters) - As the U.S. government movedinto the second week of a shutdown on Monday with no end insight, a deadlocked U.S. Congress also confronted an Oct. 17deadline to increase the nation's borrowing power or riskdefault.
The last big confrontation over the debt ceiling, in August,2011, ended with an eleventh-hour agreement under pressure from shaken markets and warnings of an economic catastrophe if adefault were allowed to occur.
A similar last-minute resolution remained a distinctpossibility this time as well.
In comments on Sunday political talk shows, neitherRepublicans nor Democrats offered any sign of impendingagreement on either the shutdown or the debt ceiling, and bothblamed the other side for the impasse.
"I'm willing to sit down and have a conversation with thepresident," said Republican House of Representatives SpeakerJohn Boehner, speaking on ABC's "This Week." But, he added,President Barack Obama's "refusal to negotiate is putting ourcountry at risk."
On CNN's State of the Union, Treasury Secretary Jack Lewsaid: "Congress is playing with fire," adding that Obama wouldnot negotiate until "Congress does its job" by reopening thegovernment and raising the debt ceiling.
SHUTDOWN, DEBT CEILING ISSUES MERGED
The two issues started out separately in the House but havebeen merged by the pressure of time.
Conservative Republicans in the House have resisted fundingthe government for the current fiscal year until they extractsome concession from Obama that would delay or defund hissignature healthcare law, which launched Oct. 1.
Many of those conservatives want a similar condition placedon raising the debt ceiling, but in his list of debt-ceilingdemands Sunday, Boehner did not mention the Affordable Care Act,commonly known as Obamacare.
"It's time to talk about the spending problem," saidBoehner, including measures to rein in costs of entitlementprograms such as the Social Security retirement system andMedicare, the government-run health insurance plan for seniors.
Harry Reid, leader of the Democratic-led Senate, is expectedto decide soon on whether to try to open formal debate on a"clean" bill - without extraneous issues attached - to raise theU.S. Treasury's borrowing authority.
Passage of such a measure would require at least six of theSenate's 46 Republicans to join its 54 Democrats in order toovercome procedural hurdles that opponents of Obamacare coulderect.
According to one Senate Democratic aide, the debt limit hikemight be coupled with a new initiative to reform the U.S. taxcode and achieve long-term savings in Social Security andMedicare, whose expense has soared along with the population ofretirees.
Republican lawmakers have floated other ideas, such as avery short debt limit increase, which would create time for morenegotiation at the expense of further market uncertainty, andrepeal of a medical device tax.
The tax is expected to generate some $30 billion over 10years to help pay for healthcare insurance subsidies underObamacare.
Some Democrats favor repealing the tax, but they insist thatreplacement revenues be found and repeal be considered onlyafter government reopens and the debt limit is raised.
MAJOR PROBLEMS IN HOUSE
Agreement in the Senate would send the snarl of issues backinto the House, whose Republican caucus has adopted a hard lineon both Obamacare and the debt ceiling.
There may be enough votes in the House for passage of aclean bill, according to some analysts. That would requirealmost all of the House's 200 Democrats and about 20 of its 232Republicans to vote in favor. But taking such a vote wouldrequire Speaker Boehner to violate his policy against bringing avote on any legislation that is favored by less than a majorityof House Republicans.
In any case, neither side is making any move towardaccommodation, and the stakes rise with the passage of time.
For any deal to work, negotiators probably would have tochoreograph a multi-pronged approach that allows all sides todeclare victory, even if it is one that cues up another battlein mid-November or December.
While the shutdown itself is unlikely to cause majordisruption in the markets, a fight over the debt ceiling could.In the last two days of the debt-limit standoff of August 2011,the New York Stock Exchange lost 11.2 percent of its value, andthe deadlock led to a downgrade of the U.S. credit rating "AA+"from "AAA" by Standard & Poors.
The outlooks from Moody's and Standard & Poor's, the onlyagency so far to have lowered its rating on U.S. debt, are bothat "stable," but Fitch Ratings has indicated a negative outlookfor the U.S. debt rating.
All three agencies have said the U.S. debt profile hasimproved substantially over the past two years, with grossdomestic product growth, while slow, proving to be persistentlypositive and the budget deficit trending lower.
Fitch said in a note last week that the U.S. rating is atrisk in the current showdown over the debt ceiling becausefailure to raise it sufficiently in advance of the deadline,raises questions about the full faith and credit of the UnitedStates to honor its obligations.
Political gridlock remains the greatest risk to the U.S.outlook, Fitch said in its note of Oct. 1, the first day of thepartial shutdown of federal government operations.
"This 'faith' is a key underpinning of the U.S. dollar'sglobal reserve currency status and reason why the US 'AAA'rating can tolerate a substantially higher level of public debtthan other 'AAA' sovereigns," Fitch said.
Investors have so far been relatively sanguine about theapproaching debt ceiling deadline, but measures of anxiety, suchas the Chicago Board Options Exchange's Volatility Index,have begun trending up since the shutdown began last Tuesday.The VIX rose 18 percent last week and briefly hit its highestlevel since June.
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