How returning deficits impact Main Street

For the past four years, the US government actually managed to live within its means, paying current bills out of current income. Instead of borrowing, it paid off some of the debts it had run up.

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But now, government spending is soaring, income is dropping, and the government will once again run in the red – with new estimates putting the budget deficit this year up sharply to $165 billion. Most private forecasters say the problem will get worse next year.

On Capitol Hill this week, Federal Reserve Chairman Alan Greenspan said that federal budget surpluses had helped hold down interest rates and spur economic growth. While noting that some factors leading to the return of deficits are temporary, he warned, "Unfortunately, there are also signs that the underlying disciplinary mechanisms that formed the framework for federal budget decisions over most of the past 15 years have eroded."

The war on terror has obviously played a role in the US financial picture, with defense spending up almost 16 percent so far this year, according to figures from Economy.com, a consulting firm. But domestic spending has also soared, with Medicare up 10 percent, Medicaid up 15 percent, and unemployment programs up 70 percent.

And as elections have approached, Congress has loosened the purse strings. For example, it passed a farm bill estimated to cost $190 billion over 10 years and is now debating costly prescription-drug benefits. Meanwhile, President Bush, who ran as a fiscal conservative, has yet to veto a single spending bill.

"If you have a deficit for one year, that is not a big deal," says Gus Faucher, senior economist at Economy.com. "The concern is if you have a structural imbalance – a long-term divergence between taxes and spending."

Deficits for a decade?

And that is what some private forecasters see. "We are looking at budget deficits through the end of the decade and into the middle of the next," says Stanley Collender, managing director of the Federal Budget Consulting Group at Fleishman-Hillard Inc. "Higher government borrowing almost certainly means higher interest rates for the average person."

For example, he says, "In a year or two, as adjustable-rate mortgages that people refinanced last year start to come due, they are going to adjust upwards by two full percentage points or more. And that is the equivalent of putting a tax on homeowners."

Mitchell Daniels Jr., director of Mr. Bush's Office of Management and Budget (OMB), takes a more optimistic view of the government's financial outlook.

The current budget deficit – at 1.6 percent of gross domestic product (GDP) – "is pretty small, particularly compared to those coming out of recessions," he says. Still, he told reporters at a Monitor breakfast this week, "I treat any deficit as a negative phenomenon."

Mr. Daniels disputes the link between deficits and interest rates, and argues that the government has "a fighting chance to get back to balance by 2005." Yet he says that eliminating red ink is contingent on "three big ifs": an economy performing to expectations, the absence of major unexpected events, and holding down nondefense spending. "It won't be easy, but we are not going to assume the defeat of the American taxpayer," Daniels says.

Many forecasters say Daniels's assumptions are overly optimistic. Next year, OMB is projecting the federal budget deficit will decline to $109 billion. Republicans on the Senate Budget Committee are predicting a fiscal 2003 deficit of $194 billion.

Some of the government's financial problems are temporary, related to last year's recession. For example, a falling stock market held down the government's take from the capital-gains taxes levied on profitable stock sales. Receipts in this area were down $80 billion, or 28 percent, according to OMB data.

The tax cut passed in June 2001 also held down the government's income. Without the tax cut, the deficit this year would be $124 billion rather than $165 billion, OMB says.

The squeeze on pocketbooks

In the long term, federal budget deficits reach into voters' pocketbooks in a variety of ways, economists say. "If the government is borrowing money, that means there is less available for private investment," says Economy.com's Mr. Faucher. "Eventually, that is going to mean we will have slower economic growth down the road."

During election year 2000, politicians talked about employing a "lockbox" to keep Social Security revenues from being used to fund other programs. Currently, Social Security takes in more in taxes than it uses to pay benefits. That will change when the baby-boom generation begins to retire in the next decade and benefit costs will outpace Social Security tax receipts.

Because the government needs to borrow now to cover the gap between its income and expenses, it is not paying down the federal debt. As a result, it will be harder to borrow in the future to solve Social Security's coming shortfall. "Wall Street's appetite for more debt to help fix Social Security is not going to be that great," Mr. Collender says.

Daniels cautions that it is very difficult to forecast precisely what will happen in the federal government's financial future. "Now the federal government has expanded to a $2 trillion enterprise. If you miss by a couple of percent, you miss by a lot of money."