Maybe it's because Boston is different, a semi-detached city in one of the US's most liberal states. But the news that the world's biggest economy had had its creditworthiness challenged for the first time by the upstart rating agency Standard & Poor's (S&P) hardly seemed to register with the locals.

No one I met fulminated about loss of economic sovereignty or that S&P, whose purblind approval of junk mortgage debt as triple A was one of the causes of the financial crisis, had finally over-reached itself. Bostonians seemed unconcerned. Perhaps this was because it was just one more surreal moment in the pantomime that is American economic and political life.

That was how the markets judged the news. There was a momentary tremor in the Dow Jones. Some analysts shrugged it off; others thought it profoundly serious. But soon the markets were on the rise again as if nothing had happened.

The Obama administration played it down. Tim Geithner, the secretary of state for the Treasury, said that S&P was behind the political curve; the prospects for a bipartisan deal were now better than they had been for months. If the hope was to provoke a change in the debate about the US's record budget deficit, S&P must have been disappointed.

The Republicans rehearsed their battle cry that Obama was mortgaging the future and that the only plan in town to respond to the agency's "wake-up call" was their own – to take federal spending back to pre-modern levels, while offering further tax relief to the rich. To all this Democrats are ferociously opposed.

You can see why. The Republican position, set out in detail by Paul Ryan, the Republican chair of the congressional budget committee, is not really a budget plan at all. It is a map for dismantling the US state so that it would do little more than provide threadbare pensions and healthcare for the very poorest and almost nothing else, with even defence in the line of fire. Democrats believe in a different role for the state and that the boom story with no role for public spending on science and infrastructure is a nonsense. It is a battle for the very soul of the United States.

For months, President Obama has played the conciliator. In December, he agreed to extend the Bush 2001 and 2003 tax cuts that have so grievously undermined the US's long-run budgetary position, once again giving ground and so implicitly accepting the logic of the Republican position.

But to general surprise, 10 days ago he showed unexpected spine in a set-piece speech. Turning on his tormentors, he declared that the state was essential to economic growth and what he described as the US's social compact. Its dismantlement was off-limits on his watch. There would be painful cuts under his deficit-reduction plan, including cuts to defence, but it would involve tax increases for the rich. Warren Buffett, he declared, did not need another tax cut.

The battle is about to become very real. On 16 May, the US will exceed the legal $14.3 trillion limit for its national debt. There has to be a vote to allow it to rise. What worries S&P is that the two parties are still far apart, with the Republicans taking positions that seem to allow no room for reason or compromise.

The threat of the US government closing down will probably be averted, but the poisonous atmosphere surrounding the role of the state and taxation allows no realistic budget bargaining. In the gap, debt and deficits will carry on rising unsustainably, hence the first "negative watch" on US public debt.

The Republican position is part sheer lunacy, but in part it also draws on deep roots and it is hard to disentangle the two. For lunacy, look no further than the debate about whether or not Barack Obama was born in Honolulu and thus eligible to be president. I arrived in the US as billionaire property dealer and publicity-hungry Donald Trump, plainly positioning himself for the Republican presidential nomination race, was saying that his newly employed investigators into Obama's birth were discovering some interesting material, although he refused to say quite what. Obama's birth certificate is on public release and Dr Chiyome Fukino, former director of health in Hawaii, has repeatedly said that it is genuine .

Trump must know it is a slur but can't resist it because a segment of the public is so hungry for such material, even if it is a palpable lie. His approval ratings have soared. And this is where the debate about the debt intersects with the daffy birther movement (those who question whether Obama really is an American and thus eligible for the presidency). A large constituency in the US is disoriented by the continual squeeze on middle-class American living standards, the fall-out of the banking crisis and the rise of China. Taken together, they spell a US in decline and it is felt personally. For them, the US's problems stem from having strayed from the ideals of the founding fathers and the lessons from the frontier .

This is why Sarah Palin's homespun, God-fearing philosophy formed in the last American frontier – Alaska – has such political resonance. Her TV series, Sarah Palin's Alaska, has her climbing rock faces and cooking in the wild, relying on her own capabilities and faith to get her through. No dependency culture here. More of that is what is now needed, not Obama's cleverness and moderate faith in government. Obviously he can't have been born an American.

It is powerful, but it is deluded and self-delusion runs deep in the US. Even the smart people at MIT, where so much US innovative technology originates, buy the cultural assertion that their success is all about individual entrepreneurship and brilliance; the cumulative trillions of US government grants are a side-show. Too few see growing federal debt as the necessary flipside of the banking crisis. The state is cast as the public enemy, not its friend.

The rows may feel as if they do not concern ordinary Americans and, as before, the politicians will find a compromise as the constitution compels them to. This time, though, there is more sulphur in the air. The US's problems are real; there is a fork in the road. It took searing depression to break the self-delusion in the 1930s. It may take disaster again to disabuse the American majority of the idea that the motley crew – Palin, Trump, Murdoch and Fox News, Paul Ryan, US bankers and shock jocks – are not on the side of reason. Until then, beware. A superpower that has lost its grip on reality is very dangerous indeed.