Failure to raise the US debt ceiling in a timely manner could sink investors' confidence in the economy, Federal Reserve chief Ben Bernanke warned Tuesday.
The Fed chairman called the impasse in Congress over raising the $14.29 trillion borrowing cap understandable but ill-advised.
"I fully understand the desire to use the debt limit deadline to force some necessary and difficult fiscal policy adjustments, but the debt limit is the wrong tool for that important job," Bernanke said in a speech in Washington.
"Failing to raise the debt ceiling in a timely way would be self-defeating if the objective is to chart a course toward a better fiscal situation for our nation."
The United States has never defaulted on its debt but is edging dangerously close. The government will run out of room to spend more on August 2 unless Congress bumps up the debt ceiling.
But Republican lawmakers, especially in the House of Representatives, are refusing to support such a move until the White House agrees on huge cuts to spending.
Bernanke said that putting in place sustainable fiscal policies was a "daunting" challenge "crucial for our nation."
"History makes clear that failure to put our fiscal house in order will erode the vitality of our economy, reduce the standard of living in the United States, and increase the risk of economic and financial instability."
However, he said, "In debating critical fiscal issues, we should avoid unnecessary actions or threats that risk shaking the confidence of investors in the ability and willingness of the US government to pay its bills."
President Barack Obama earlier Tuesday warned of a new economic meltdown if the ceiling is not lifted in time.
"We could actually have a reprise of a financial crisis, if we play this too close to the line," Obama told NBC television Tuesday.
"We're going be working hard over the next month. My expectation is we're going get it done in a sensible way. That's what the American people expect."
Treasury Secretary Timothy Geithner met with Republican and Democratic lawmakers Tuesday to try to find an exit to the impasse.
Republicans back trillions of dollars in spending cuts and oppose tax increases to put the economy on a sustainable track after the worst recession in decades resulted in ballooning budget deficits and public debt.
Obama's Democrats are open to spending cuts as long as they do not harm the social safety net, such as social security and Medicare programs, and keep on track the weak economic recovery.
Bernanke hit out at recent suggestions that the Treasury could avoid a technical default by juggling principal and interest payments on debt outstanding.
"Even a short suspension of payments on principal or interest on the Treasury's debt obligations could cause severe disruptions in financial markets and the payments system, induce ratings downgrades of US government debt, create fundamental doubts about the creditworthiness of the United States, and damage the special role of the dollar and Treasury securities in global markets in the longer term."
He said interest rates would likely rise, slowing the recovery and deepening the deficit problem by increasing required interest payments on debt.
The Treasury estimates that a financial crisis resulting from a default would have catastrophic economic consequences and could potentially cost millions of American jobs, at a time of high unemployment that hit 9.1 percent last month.
Fitch Ratings last week warned the United States could lose its gold-plated credit rating if it fails to raise its debt ceiling to avoid defaulting on loans. Similar alarms have come from Standard & Poor's and Moody's.
China, by far the top holder of US debt, has expressed concern that the massive US stimulus effort launched to revive the economy has led to mushrooming debt that erodes the value of the dollar and its Treasury holdings.
China cut its holdings of US Treasury securities in March for the fifth month in a row, to $1.145 trillion, a 2.6 percent decline from an October peak, US data showed last month.