Swelling Deficit Could Slow Recovery

From Forbes.com

In the midst of the worst U.S. economic recession in the post-war period, President Barack Obama in February presented Congress with a budget blueprint that packaged an exceptionally expansionary policy with the rhetoric of fiscal responsibility. However, the prospect of the budget deficit remaining in excess of $1 trillion per year over the next decade raises a number of concerns about longer-term interest rates and the value of the dollar.

1. Inflation danger. The prospective rise in the federal debt-to-GDP ratio to 82% by 2019 raises the likelihood of high long-term interest rates that would be harmful for longer-term economic growth. Large public borrowing requirements would require the Federal Reserve to follow a more restrictive monetary policy approach to contain inflation, while a large rise in the public debt-to-GDP ratio could put the U.S. government's AAA debt rating in jeopardy.

2. Entitlement program concerns. The projected trajectory of the deficit over the next decade is likely to deepen concern about the major challenges to the U.S. public debt outlook in the decades ahead due to the unfunded nature of U.S. social security programs as the baby boom generation reaches retirement. In the absence of policy changes, Social Security (the state pension) and Medicare (government health care for the elderly) outlays will together increase from 8.5% of GDP today to 12.5% of GDP by 2030.

3. Pressure on the dollar. The prospective large public-sector borrowing requirements over the next decade are likely to raise concerns for the dollar. Already foreigners finance close to 50% of the U.S. budget deficit (lumping together central banks, foreign wealth funds, non-U.S. pension and investment funds and non-U.S. corporations) and hold over $3 trillion in U.S. government paper. It would seem implausible to expect foreigners to indefinitely fund such large deficits, especially when they are already voicing concerns about fiscal sustainability.

4. Interest rates. The prospect of large budget deficits is undermining the Federal Reserve's efforts to reduce long-term interest rates as a means to stimulate the economy and stabilize the housing market. In March, after having reduced the federal funds rate to a range between zero and 0.25%, the Fed indicated that it would try to reduce long-term interest rates by: