Why Deficits Matter

Although the ramifications of persistent and growing federal deficits are not often well-understood by the public, they will become increasingly relevant in the future. Eventually, all those debts will have to be paid off, in the form of higher taxes or spending cuts (unless, of course, the United States inflates its way out of debt or defaults—both unnerving, if far-fetched, possibilities). The country may also face higher borrowing costs in the future, in the form of hikes in interest rates, which could hamper the American economy and even induce a recession. If that's not bad enough, in just a few years, budget deficits will grow even bigger as the government faces increasing costs associated with the retirement of the baby boomer generation.

By not preparing for this inevitability, the federal government is essentially doing what an individual in debt might do—that is, paying off current obligations by taking out additional loans—but instead of mortgaging a house, the government is borrowing from future economic growth. "By borrowing from abroad to finance U.S. investment, we our shortchanging our future standard of living," says Maya MacGuineas, president of the Committee for a Responsible Federal Budget. "From a generational perspective, throwing a fiscal party and passing along the bill is extremely unfair."

The Deficit Problem

The federal budget deficit in 2004, the largest in American history, came after an unprecedented three consecutive years of increases in the deficit, and the problem shows no signs of abating: the 2005 deficit was the third highest on record, and 2006 looks to hit similar levels, especially once costs for the wars in Iraq and Afghanistan, as well as the rebuilding of Katrina, are factored in.

It's true that the national debt as a share of GDP has not yet surpassed the peacetime peak it reached during the Reagan administration. But the debt's rapid rate of growth, combined with the coming budgetary pressures associated with an aging population, is worrisome, especially if the debt starts increasing faster than GDP. And in the midst of this crisis, the Bush administration is depriving the government of revenue with massive tax cuts for a wealthy minority, while refusing to do anything to restrain spending coming from Congress. (The president has promised to cut the federal deficit in half by 2008, but few think he will hit that target.)

Over the past few decades the United States has gone from the world's largest lender to its biggest borrower. Some amount of government debt is sustainable, but it is dangerous if the borrowed money is not being invested in the infrastructure and human capital necessary to produce future growth down the road. And right now it is not. The money America borrows goes primarily into consumer spending, housing improvements, and more loans—none of which are helping the country to generate future wealth to pay the interest on the loans it is taking out at present.

Other industrialized countries, such as Japan, may sustain larger budget deficits than the United States, but their high private sector savings rates offset that government borrowing. In contrast, the U.S. household savings rate recently went negative for the first time since the Great Depression. And running a budget deficit has bigger consequences for economies with low savings, argues Brad Setser, head of global research at Roubini Global Economics and a former Treasury economist.

In general, deficits can hamper future economic growth by ensuring that a bulk of future wealth will be dedicated to paying back loans. Sustained deficits can also drive up interest rates and divert funds away from private investment.

In theory, Americans care about the national deficit, but most consumers are seeing benefits from all this borrowing now, and they won't see the downsides until long in the future. Asian governments continue to borrow billions of dollars from the federal government in order to keep the dollar artificially high, flooding the United States with cheap imports that benefit consumers. That buying spree has also kept interest rates artificially low, helping to fuel the current economic boom. At present, the people who benefit from this system have very little incentive to change it, and every reason to push the associated problems onto future generations.

At some point the debt will become unsustainable, but it's tough to pin down exactly where that point of no return is. If foreign central banks started worrying about the United States' ability to repay its obligations, and began to sell or even buy fewer dollar-denominated assets, it could lead to a run on the dollar, which would force up interest rates and potentially put the U.S. economy into a recession. Among economists, a debate continues to rage over how painful the correction to the current account deficit may be, but a rare consensus is emerging that the fiscal and current account deficits are unsettling and demand some sort of response.

Why the Current Account Deficit Matters

Most experts think the United States is too big to fail—that it would never default on its debts. After all, that would be the most catastrophic Chapter 11 in history, with creditors losing unthinkable sums of money. The global economy would likely go into recession. Who can imagine it happening?

Addison Wiggin, editor of The Daily Reckoning, a financial newsletter, willingly admits that he holds a minority opinion in the policy world. His new book, Empire of Debt, co-written with Bill Bronner, argues that even seemingly-invincible empires can collapse because of bad habits. But nowadays Wiggin and Bronner aren't the only ones comparing the United States to the Roman Empire just before its fall; last November the U.S. Comptroller General, David M. Walker, made the same analogy, citing the "fiscal irresponsibility" of the federal government.

Indeed, an increasing number of mainstream economists are issuing dire warnings about the U.S. debt, and many academics are converging on the view that the budget and current account deficits could lead to fiscal disaster in the future. In a series of pronouncements last year, then-Federal Reserve Chairman Alan Greenspan counseled that "unless we do something to ameliorate [the federal deficit] in a very significant manner," it may "cause the economy to stagnate or worse." And the deficit-to-GDP ratio grew large enough in 2004 for the International Monetary Fund to point out that the rising debt "pose[d] significant risks for the rest of the world."