The Cost of the Federal Budget Deficit

Tax hikes and higher interest rates plus inflation's bite top the list.

By Jerome Idaszak, Associate Editor, The Kiplinger Letter

March 30, 2009

The massive economic rescue plan carries with it an onerous price: a ballooning federal deficit that will equal 12.2% of the gross domestic product (GDP) this year, a post-World War II high.

President Barack Obama has in his budget for fiscal year 2010 a deficit of $1.3 trillion and promises to halve that by 2013. But success is a long shot, requiring a lot to go just right. For the next decade or so, annual deficits much below $700 billion will be tough to come by, and some are bound to top $1 trillion.

The result will be a huge amount of debt to be repaid. Uncle Sam already owes an amount equal to 41% of GDP. By 2019, that could double as expenses for Medicare, Social Security and Medicaid increase as the huge bulge of baby boomers continues to retire. Interest on outstanding debt will claim a larger share of the budget, from 4.2% this year to about 11% by 2013. "It will be the fastest growing category of the budget," says budget watcher Stan Collender, managing director for Qorvis Communications.

The inevitable consequence will be higher taxes -- or less money to spend on everything else, from food safety to road building, education, health care, energy, the environment and even homeland security and defense. Washington policymakers will face a series of tough choices. And the ambitious White House plans for reforms in health care, education and energy policy may be out of reach. Obama will be forced to cut back or delay his plans.

In any case, Uncle Sam will have to borrow much more to foot the tab. Long-term Treasury rates will climb to attract the investors needed. As U.S. households increase their savings in a new, more austere economic climate, their 5% share of Treasuries will increase. In the early 1990s, before the allure of stocks and real estate surged and bond yields fell, households held about 20% of outstanding Treasuries. But even if that level were regained, and that's unlikely in the short run, it wouldn't be enough to fund the $4.2-trillion increase in borrowing by the Treasury in the next few years.

To coax foreigners to continue lending the U.S. money, interest rates will move several percentage points higher. There won't be any escape from inflation, either. All the cash that the Federal Reserve is pumping into the ailing economy will create excesses as consumer spending recovers and the slack in the economy is absorbed, a shift likely to begin in early 2011.

Count on the central bank to raise short-term rates. But by the time the rate hikes start to constrain price increases, inflation will be running at around a 4% annual rate. It's a situation of Obama making a painful trade-off, opting to dose the patient in order to head off disaster now despite the certain misery from side effects later. But as Diane Swonk, chief economist with Mesirow Financial in Chicago, says: "The cost of doing nothing is greater than the cost of doing something. That's the crisis we're in."

For weekly updates on topics to improve your business decisionmaking, click here.