Back when a trillion was an unimaginably large number, President Reagan confided that he was having trouble comprehending how much a trillion dollars was: "And the best I could come up with is that if you had a stack of thousand-dollar bills in your hand only 4 inches high, you'd be a millionaire. A trillion dollars would be a stack of thousand-dollar bills 67 miles high."
Reagan imagined this tower of greenbacks in February 1981, at the beginning of a deep recession that many people believe will be equaled in the months ahead. Back then, a trillion dollars represented an extraordinary threshold -- the cumulative debt for the federal government since it first borrowed money to finance the Revolutionary War. In scarcely a generation, the United States government has gone from owing a trillion dollars to borrowing that much just to make the rent.
In 2009, it is possible that the U.S. budget deficit for a single fiscal year will reach $1 trillion. At a time when U.S. businesses and households are being forced to reduce their debts -- "deleverage," in the recent parlance -- the federal government is leveraging more than ever. Only nine months ago, the Congressional Budget Office predicted that the budget deficit for 2009 would be $198 billion. The actual number may be five times as large.
Officially, Congressional Budget Office Director Peter Orszag has said that the slowing economy and the costs of emergency action connected to the financial crisis could push the deficit to $750 billion next year. But that figure doesn't include other anticipated costs, such as an economic stimulus plan of $300 billion or more, other steps to shore up the banking system, and lost tax revenue as the recession deepens.
The first budget expert to use the $1 trillion number was Maya MacGuineas, president of the Committee for a Responsible Federal Budget, based on a guess about declining revenues and some simple addition involving the proliferating obligations of the Treasury Department and the Federal Reserve in trying to unfreeze the financial system. Some of these costs are known -- at least $120 billion has already been drawn by insurance giant American International Group, for example -- but other expenses, such as the cost of recapitalizing Fannie Mae and Freddie Mac -- are not yet clear, MacGuineas noted.
William Gale, director of economic studies at the Brookings Institution, agrees that the deficit could reach $1 trillion. "I think hardly anyone is worrying about that right now," he said. The reasons for this lack of concern go beyond the distractions of a historic election and the depth of the economic emergency, he said. After a generation in which the budget deficit has steadily diminished as a worry for the public and its elected representatives in Washington, Gale said, "there are some lessons that have been forgotten." One of those forgotten lessons is that it is easier to build the tower of debt than it is to dismantle it. Another is that even "temporary" deficits become permanent unless they become the focus of the political system -- a focus that is entirely lacking these days.
Why Deficits Matter
Budget deficits are bad, economists say, when they grow large enough to push up interest rates and retard growth. In 1981, when Reagan took office, the deficit was 2.6 percent of gross domestic product, barely above the long-term average of about 2.5 percent of GDP. A recession, tax cuts, and defense spending combined to drive the deficit up to 6 percent of GDP in 1983, and it remained consistently above average for the next decade.
Deficits cause higher interest rates because the government competes with businesses and consumers to borrow money, according to conventional economic theory. The science of quantifying this effect is a little slippery, but Gale's research estimated that for each percentage point of GDP that the deficit rises, long-term interest rates increase by 0.4 to 0.7 percentage points. According to this yardstick, for the decade of higher deficits that lasted until 1993, government borrowing raised interest rates as much as 1 percentage point each year. Compounded over 10 years, this borrowing crowded out a lot of growth. In 1990, high interest rates were crucial in throwing the nation into a recession, and rates remained troublesomely high during a slow recovery in 1992.
A $1 trillion deficit next year would put the nation's overspending in record territory -- somewhere above 6 percent of GDP, and perhaps close to 7 percent (depending on how much the economy shrinks in the coming months -- a bigger downturn means a bigger percentage). Using Gale's rule of thumb, this deficit level could raise long-term interest rates by perhaps 2 percentage points -- assuming a few things that are hard to pin down.
One of those assumptions is that the increase in the deficit represents a fairly long-term upward adjustment in the government's imbalance between spending and revenue. On the surface, much of the spending that will drive next year's deficit seems like onetime expenses -- the hundreds of billions of dollars to nationalize Fannie Mae, Freddie Mac, and big companies such as AIG; the hundreds of billions more to nationalize banks; and the hundreds of billions that may go to another massive economic stimulus plan, either in a lame-duck session of Congress this fall or early next year. Much of the money flowing out of the Treasury in 2009 to underwrite these ventures will be flowing back over the coming years, Gale said, as the government sells off its stakes in companies and gets payment on its loans.
On the other hand, Gale admitted, a great deal of uncertainty remains over when Treasury can recover its costs, how much it will get, and whether it will have to shell out more money. Meanwhile, he said, deficits were already expected to rise sharply because of the mounting costs of entitlement programs such as Social Security and Medicare. A $1 trillion deficit may make it appear futile for the next president to propose politically palatable steps to address the entitlement problem, Gale said.
And then there's the challenge posed by the scheduled expiration of President Bush's tax cuts in 2011. Current CBO projections assume a big burst of revenue after tax rates rise for many consumers and most businesses -- just when the economy is likely to be emerging from a recession. John McCain has promised to continue all the Bush tax cuts if he is elected president, and Barack Obama vows to continue them for all except those making more than $250,000. So the big burst may never materialize.
So Far, Lower Rates
Simon Johnson, former research director at the International Monetary Fund, said that few economists are worried about a record budget deficit for the United States next year because long-term interest rates are already low and expected to go at least 1 percentage point lower, according to most predictions for 2009. That is what happens during recessions, when the demand for capital dries up, said Johnson, now a senior fellow at the Peterson Institute for International Economics.
But the situation is complicated by another factor -- the unusual uncertainty over the availability of credit. Even after the Federal Reserve Board's decision on Wednesday to lower short-term interest rates to 1 percent, the difference between the Fed's rate to banks and what banks are charging to customers for loans is historically very high, and qualifying for loans has become much more difficult for would-be borrowers. If the financial rescue plan works, this "risk premium" will ease over time, but Johnson concedes that it will remain elevated, perhaps even during a recovery.
The larger question about a $1 trillion deficit, according to Johnson, is whether it represents a historic step toward out-of-control fiscal policy. Unusual among economies around the world, the United States has been relatively virtuous when it comes to debt and deficit spending, he said, and our fiscal conservatism has been a major reason why foreign investors have viewed the United States as the safest place to keep their money. "I don't think that a deficit of 6 percent of GDP" will convince investors that the United States will be unable to fund its obligations, Johnson said. Even with the higher deficit next year, a total national debt of $11 trillion would amount to about 70 percent of GDP, while many developed nations have staved off crisis with ratios well over 100 percent.
Nevertheless, we are less virtuous than we used to be. In 1981, the $1 trillion national debt was about 20 percent of yearly GDP. Since then, the economy has roughly tripled in size while the debt has grown by a factor of 10 -- it is now about $10.5 trillion. Back then, Reagan could provoke outrage by noting that the government would pay $90 billion in annual interest on the national debt. In the fiscal year that ended on September 30, the government paid $450 billion in interest.
The increase in borrowing and interest expenses is a cultural trend. In 1981, the debt held by American households was just under 70 percent of median after-tax income; by 2007, that proportion had doubled to 140 percent of take-home pay. A large share of this increase has come in home mortgage debt -- its share of the total has risen much faster than has borrowing for other purposes.
For the deficit and the debt to really matter, Johnson said, investors would have to conclude that the United States was no longer the safest bet in the world, and the spread of the financial crisis beyond the United States has helped us in that regard. As European nations and other countries have seen the credit crunch strain finance and economic growth, investors' confidence in the United States has actually increased in the last few weeks, Johnson said. This trust is reflected in higher prices and lower yields for Treasury bills and an increase in the value of the dollar, as foreigners put their money in American assets.
The Big Debate
The issue of international confidence is the basis of a significant debate playing out behind the scenes in the Democratic Party, Gale said. On one side are fiscally conservative Democrats who are worried about the threat of the budget deficit and who seek action to deal with growing entitlement obligations. Not surprisingly, this group includes veterans of the Clinton administration, which made taming the deficit its top economic priority: former Treasury Secretaries Robert Rubin and Lawrence Summers, and former White House Chief of Staff Leon Panetta, who co-chairs the Committee for a Responsible Federal Budget.
On the other side are many Democrats who don't want the threat of impending deficits to get in the way of political priorities, particularly health care reform. The most outspoken and influential supporter of this view is economist and New York Times columnist Paul Krugman, who recently added a Nobel Prize to his resume. Krugman has tirelessly warned that fiscal conservatives exaggerate the threat of budget deficits to hold back progressive reforms.
A clue to where this debate stands can be found in recent comments by Rubin, who has ruled out serving in an Obama administration but is playing a big role in the campaign's agenda. In a CNN interview last weekend, Rubin was asked whether the new administration should choose deficit-cutting -- as he did in 1993 -- or fiscal stimulus as its priority. Rubin's answer reflected what Obama has been saying: both. After recommending "a very large fiscal stimulus now," Rubin called for "a real commitment to re-establishing sound fiscal conditions in this country over time, because failure to do that can create ... great concerns in the international markets. That undermines our bond market, undermines our currency. And that would be hugely counterproductive."
Neither Obama nor McCain has said what, if any, spending he would sacrifice to reduce the deficit. The eventual answer, Gale said, is crucial in judging whether the deficit might become the problem for the economy that it was 25 years ago. In 1983, he said, divided government restrained fiscal policy, even without a threat like the one posed by the growth in entitlements. If the $1 trillion deficit is to be temporary, Washington will have to focus on deficit-cutting, as it did in 1990 and 1993, but Gale sees no sign of that happening. Sooner or later, he said, the next president will have to make reducing the deficit a major priority -- either before or after events in the financial markets force him to.