2009 federal deficit surges to $1.42 trillion

[October 17, 2009]  WASHINGTON (AP) -- What is $1.42 trillion? It's more than the total national debt for the first 200 years of the Republic, more than the entire economy of India, almost as much as Canada's, and more than $4,700 for every man, woman and child in the United States.

It's the federal budget deficit for 2009, more than three times the most red ink ever amassed in a single year.

And, some economists warn, unless the government makes hard decisions to cut spending or raise taxes, it could be the seeds of another economic crisis.

Treasury figures released Friday showed that the government spent $46.6 billion more in September than it took in, a month that normally records a surplus. That boosted the shortfall for the full fiscal year ending Sept. 30 to $1.42 trillion. The previous year's deficit was $459 billion.

As a percentage of U.S. economic output, it's the biggest deficit since World War II.

"The rudderless U.S. fiscal policy is the biggest long-term risk to the U.S. economy," says Kenneth Rogoff, a Harvard professor and former chief economist for the International Monetary Fund. "As we accumulate more and more debt, we leave ourselves very vulnerable."

Forecasts of more red ink mean the federal government is heading toward spending 15 percent of its money by 2019 just to pay interest on the debt, up from 5 percent this fiscal year.

President Barack Obama has pledged to reduce the deficit once the Great Recession ends and the unemployment rate starts falling, but economists worry that the government lacks the will to make the hard political choices to get control of the imbalances.

Friday's report showed that the government paid $190 billion in interest over the last 12 months on Treasury securities sold to finance the federal debt. Experts say this tab could quadruple in a decade as the size of the government's total debt rises to $17.1 trillion by 2019.

Without significant budget cuts, that would crowd out government spending in such areas as transportation, law enforcement and education. Already, interest on the debt is the third-largest category of government spending, after the government's popular entitlement programs, including Social Security and Medicare, and the military.

As the biggest borrower in the world, the government has been the prime beneficiary of today's record low interest rates. The new budget report showed that interest payments fell by $62 billion this year even as the debt was soaring. Yields on three-month Treasury bills, sold every week by the Treasury to raise fresh cash to pay for maturing government debt, are now at 0.065 percent while six-month bills have fallen to 0.150 percent, the lowest ever in a half-century of selling these bills on a weekly basis.

The risk is that any significant increase in the rates at Treasury auctions could send the government's interest expenses soaring. That could happen several ways - higher inflation could push the Federal Reserve to increase the short-term interest rates it controls, or the dollar could slump in value, or a combination of both.

The Congressional Budget Office projects that the nation's debt held by investors both at home and abroad will increase by $9.1 trillion over the next decade, pushing the total to $17.1 trillion decade under Obama's spending plans.

The biggest factor behind this increase is the anticipated surge in government spending when the baby boomers retire and start receiving Social Security and Medicare benefits. Also contributing will be Obama's plans to extend the Bush tax cuts for everyone except the wealthy.

The $1.42 trillion deficit for 2009 - which was less than the $1.75 trillion that Obama had projected in February - includes the cost of the government's financial sector bailout and the economic stimulus program passed in February. Individual and corporate income taxes dwindled as a result of the recession. Coupled with the impact of the Bush tax cuts earlier in the decade, tax revenues fell 16.6 percent, the biggest decline since 1932.

Immense as it was, many economists say the 2009 deficit was necessary to fight the financial crisis. But analysts worry about the long-term trajectory.

The administration estimates that government debt will reach 76.5 percent of gross domestic product - the value of all goods and services produced in the United States - in 2019. It stood at 41 percent of GDP last year. The record was 113 percent of GDP in 1945.

Much of that debt is in foreign hands. China holds the most - more than $800 billion. In all, investors - domestic and foreign - hold close to $8 trillion in what is called publicly held debt. There is another $4.4 trillion in government debt that is not held by investors but owed by the government to itself in the Social Security and other trust funds.

The CBO's 10-year deficit projections already have raised alarms among big investors such as the Chinese. If those investors started dumping their holdings, or even buying fewer U.S. Treasurys, the dollar's value could drop. The government would have to start paying higher interest rates to try to attract investors and bolster the dollar.

A lower dollar would cause prices of imported goods to rise. Inflation would surge. And higher interest rates would force consumers and companies to pay more to borrow to buy a house or a car or expand their business.

"We should be desperately worried about deficits of this size," says Mark Zandi, chief economist at Moody's Economy.com. "The economic pain will be felt much sooner than people think, in the form of much higher interest rates and much higher rates of inflation."

If all that happened rapidly, it could send stock prices crashing and the economy tipping into recession. It could revive the pain of the 1970s, when the country battled stagflation - a toxic mix of inflation and economic stagnation.

Paul Volcker, then the chairman of the Federal Reserve, responded by raising interest rates to the highest levels since the Civil War in a determined effort to combat a decade-long bout of inflation. His campaign pushed banks' prime lending rate above 20 percent in 1981 and sent the country into what would be the longest post-World War II downturn before the current slump. Unemployment jumped to a postwar high of 10.8 percent in December 1982.

The battle against inflation, though, was won.

Most economists say we have time before any crisis hits. In part, that's because the recession erased worries about inflation for now. In its effort to stimulate the economy, the Fed cut a key interest rate to a record low last December and is expected to keep it there possibly through all of next year. Demand for loans by businesses and consumers is so weak that low rates are not seen as a recipe for inflation.

Some hold out hope that Congress and the administration will act before another crisis erupts.

Robert Reischauer, a former head of CBO, said that in an optimum scenario, Congress will tackle the deficits next year. A package of tax increases and spending cuts could be phased in starting in 2013 and gradually grow over the next decade.

The administration has pledged to include a deficit-reduction plan in its 2011 budget, which will go to Congress in February.

Stanley Collender, a budget expert at Qorvis Communications and a former staff aide to House and Senate budget committees, cautions that unless investors show nervousness about the debt, the budget debate next year could feature more posturing between the two parties than any real action to fix the problems.

But Alan Greenspan, who led the 1983 commission that made changes to avert a crisis in Social Security, said in an interview that he was optimistic that politicians will eventually work out a solution.

"I have always been a great supporter of Winston Churchill's statement about the United States," Greenspan said. "The United States can be counted on to do the right thing, after having tried all other conceivable alternatives."

[Associated Press; By MARTIN CRUTSINGER]

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