“Investors can relax,” says Evan Bayh, former US Senator for Indiana, at a luncheon sponsored by the Asia Society. He says the United States Congress will vote to raise the federal debt ceiling in the first week of August, but the process he describes is likely to frighten investors, even if the final outcome is the right one.

The US government hit its debt ceiling of over $14 trillion in May, prompting US Treasury secretary Tim Geithner to suspend investments in federal retirement funds until August 2, to create additional room for the US to continue to borrow, at which point his accounting tricks run out of rope.

Bayh says the ceiling will be raised, but there will be plenty of alarming headlines generated in the interim.

Bayh, a Democrat, served in the Senate from 1999 to January 2011. One of the few moderates left in the Senate, he decided not to seek re-election in despair of bipartisan paralysis. He was in Hong Kong recently at the invitation of the Asia Society to lay out his interpretation of what will drive US politics from now until the elections of November 2012.

He says the October 2008 experience of passing Tarp is a probable blueprint for how the debt ceiling will be raised. Tarp, the $700 billion Troubled Asset Relief Program, was proposed by Geithner’s predecessor Hank Paulson in the dark aftermath of the Lehman Brothers bankruptcy. It was meant to bail out banks and prevent another Great Depression, by allowing the government to buy their toxic portfolios of mortgage-backed bonds.

Although it succeeded, Tarp was vilified on the political left and right as bailing out fat-cat bankers (which it also did). What the populace often failed to understand was that if the banking system had gone down, it would have meant the impoverishment of millions of Americans and the destruction of businesses both big and small.

Bayh recollects the US Senate passed Tarp 75 to 25, with support from both parties. The measure then failed in the US House of Representatives – thus triggering a 900-point fall in the S&P 500, at which point the rebels were sufficiently spooked to reconvene and pass Tarp the next day. Armageddon averted.

Bayh says given the rigidity with which Democrats are refusing to countenance cuts to entitlements, and which Republicans are opposed to raising taxes, it will probably take a down-to-the-wire, thirty-seconds-to-midnight deal to get the debt ceiling raised in August.

In fact, that alone may not be enough to get hard-left Dems and Tea Party zealots in the House to make a deal. It might take a market crisis, something like the S&P 500 losing 900 points in one day.

That’ll focus minds.

But it will also set up markets for a real scare about the US government’s ability to service its debts. “There may be a 24-hour trading opportunity for those of you with a strong stomach,” Bayh says. He means it as a joke and the comment got a laugh. But it’s a half-joke that’s also half-true. Maybe more than half-true.

How the deal is structured is up for grabs. Bayh says the most likely package will include modest steps toward fiscal reform – something that pares back spending a bit to show the markets the US intends to address its debts, but with true reform postponed until 2013.

His less-likely scenario is that no real deal is made and the debt ceiling is raised for just a few months or weeks. This would lead to a hopscotch of repeated showdowns and short-term fixes. The US wouldn’t default, but it would keep the market on tenterhooks. Obviously no one wants this outcome.

Bayh’s least likely scenario, albeit the nicest one, is that the debt ceiling gets raised along with a comprehensive solution forged among the two parties’ leaders. Handshakes and cigars all around.

Bayh delivered a masterful review to the Asia Society audience of the politics of an anaemic recovery and indebtedness, and who will win the Presidency in 2012, as well as fielded questions ranging from US-China relations to efforts to restore bipartisan compromise. For all of that, however, you just had to be there.