US stares at a $1 trillion deficit. How bad is that?

The number ballooned amid the banking bailout. Tax hikes may lie ahead.

By , Staff writer of The Christian Science Monitor

The US government's extraordinary effort to rescue the banking system may have pulled America's economy back from the brink, but it comes at a cost – helping to push an already bloated deficit up to an estimated $1 trillion for this fiscal year.

That would be a record in today's dollars – and would represent the highest level of federal red ink as a share of the overall economy of any US budget since the 1940s. For each household, this year's deficit would pile on an extra $8,620 of federal debt.

As a result, future presidents may have to rein in spending and raise taxes to pay down that debt. If they don't, foreign lenders at some point could scale back their purchases of US debt, sending interest rates soaring.

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"There are times when you need to run up the deficit and this is one of them," says Maya MacGuineas, president of the Committee for a Responsible Federal Budget, a nonpartisan group in Washington that came up with the $1 trillion estimate. "But we ran them up when we did not need to, and we have no plan to stop running them up. We have become serial deficit spenders."

It could be worse. The rising estimates of the deficit are based in part on the calculation that tax revenues will shrink as the economy contracts and unemployment rises. If the recession is less severe because of the bank rescue, then the deficit will be smaller. If Congress enacts a new economic stimulus package, the deficit could go up.

Another unknown is the actual costs of the $700 billion financial rescue bill. In the first year of the three-year program, the US Treasury might spend $400 billion, estimates Stanley Collender, managing director at Qorvis in Washington and a budget expert. But the Congressional Budget Office is not likely to count it as a direct expense since it might be considered a loan or an investment.

"As long as you treat it as a loan or capital transaction, then you have to look at the difference between the initial expenditure and the amount you would expect to get back," says Barry Bosworth, a senior fellow at the Brookings Institution, a Washington think tank. "Maybe it will be scored at a cost of $100 billion or higher. Otherwise, the budget deficit would be way over $1 trillion."

If the deficit does reach $1 trillion this year, it would represent 7.5 percent of the gross domestic product, the highest percentage since World War II when it skyrocketed to 30 percent of GDP. "The big difference is back then we owed it to ourselves, to Americans," says David Walker, head of the Peter G. Peterson Foundation and former US comptroller general.

Mr. Walker is part of an effort called the Fiscal Wake-Up Tour, which is traveling around the nation meeting with editorial boards and holding town-hall gatherings to explain the budget situation. Next year, the group, sponsored by the Concord Coalition, will focus on solutions.

Walker's focus is not just the national debt, which will grow to more than $10 trillion this year. Instead, he is looking at the national debt plus all the unfunded promises such as Social Security and Medicare, which have no future tax revenues to cover them. "At the end of the last fiscal year, that came to $53 trillion or about $550,000 per household," he says. "We may well have passed the point where the federal government's total financial hole exceeds the net worth of all Americans."

Walker estimates the US has about five years to show fiscal responsibility: "We will have to send a strong signal we can get our house in order."

That's not going to happen this fiscal year. Congress is expected to pile on new spending, such as an $80 billion reduction in taxes for individuals who would otherwise fall under the Alternative Minimum Tax (AMT) and $8 billion in hurricane Ike relief funds. So far, Congress has only appropriated $70 billion for the Iraq and Afghanistan effort, despite the fact that the wars have been costing about $150 billion per year. And revenues are likely to be considerably lower than anticipated.

"We have fewer people working, lower corporate profits, and losses in the markets," says Mr. Collender, who says one of the implications of the huge deficit will be that any of the plans by the presidential candidates for tax cuts or new spending programs will be put on hold.

"It also makes a tax increase in the future much more likely," he says. "No one is talking about raising taxes now. But by the end of 2009 or beginning of 2010, that could be a consideration, especially if there is a threat of higher interest rates."

Higher interest rates could be in the mix if some of the world's lenders were to start to diversify their assets.

"We don't look like such a great bet anymore," says Ms. MacGuineas, who worries that the next "bubble" will be government debt.

However, not everyone sees the picture in such bleak terms. In an analysis on Wednesday, Drew Matus, US economist for Merrill Lynch & Co., projects interest rates on 10-year US Treasury bonds falling below 3 percent in large part because inflation will fall more rapidly than expected. And he anticipates supply and demand for the securities – estimated to total $3.2 trillion over five years – will be about equal. "We put our emphasis on the fundamentals over the medium term and continue to be bullish on Treasuries," he writes.

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