By John W. Schoen Senior producer
msnbc.com
updated 1/7/2009 6:47:37 PM ET 2009-01-07T23:47:37

Tuesday’s report that the U.S. budget deficit will swell to $1.2 trillion in the current fiscal year isn’t a complete surprise. President-elect Barack Obama warned this week of "trillion-dollar deficits for years to come."

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But the grim projection from the Congressional Budget Office has many taxpayers wondering: How much longer can we keep this up? And what happens if the government borrows too much?

The deficit has a number of causes: a shrinking economy has cut deeply into estimated tax revenues, hundreds of billions have spent bailing out the  financial system, and Congress has systematically failed to bring expenses and revenues in line.

With the economy still reeling, Obama and Congress are readying a recovery plan of tax cuts with new spending programs that could add another $775 billion to the deficit over the next few years.

Here’s what’s at stake for American taxpayers:

How long can the government sustain all this borrowing and spending?

The only honest answer: No one knows. For the past few decades, a number of economists, analysts and some members of Congress have been pressing to balance the federal budget; some have called it a national security issue. The U.S. has run an operating budget every year sinece 1961 except for 1999 and 2000. Meanwhile the economy has generally expanded, leading some to conclude that rising national debt isn’t a major problem.

Proponents of this idea argue that the overall level of debt is less important than its relationship to the size of the U.S. economy. If you’re carrying a $5,000 credit card balance with an annual income of $30,000, your debt load is going to ease considerably if you get a new job that pays $60,000. You could then double your debt and carry the same load on a percentage basis.

Has the government ever had to deal with this much debt?

Today, the national debt of $10.6 trillion is about two-thirds of the nation's $14.4 trillion gross domestic product. We’ve seen much higher: During World War II, the debt was more than double GDP.

But when the war ended, defense spending plunged and the economy surged, bringing the ratio back down to 60 percent by the early 1950s. That’s about where it was in the late 1980s and early 1990s before concerted efforts by Congress and the White House balanced the budget and cut that ratio below 60 percent. In the past eight years, heavy tax cuts and spending on the war and prescription drug benefits pushed the percentage back to the mid-60s.

That ratio is almost certainly headed higher. The congressionally approved bank bailout program will add at least $700 billion to the debt. Another $775 billion for the proposed recovery package would push the overall national debt closer to 85 percent of GDP.

Why are we doing this? If the deficit is so big, shouldn’t the government be trying to shrink it?

Over the long run, spending will have to be cut or taxes increased — or both. But in the short term, both of those moves would push the economy deeper into a recession that is already shaping up as one of the worst in decades.

The hope is that the government’s massive intervention can break a downward economic spiral that shows no signs of letting up. Falling home and stock prices have destroyed trillions of dollars of wealth, forcing companies and consumers to cut back. Job losses have further cut into spending and home buying, bringing more layoffs.

The flood of federal money will take time to work its way through the system; some programs will work more quickly than others. The Fed’s effort to push mortgage rates lower is barely under way, and rates already have fallen sharply. On the other hand, there’s evidence that banks are hanging on to much of the money they have received through the Treasury's so-called TARP program.

The gamble is that the economy will begin growing again and the government will recoup some of the borrowed money by selling off assets it is buying in the bank bailout program, bringing the debt-to-GDP level back down to (roughly) currently levels.

Will the plan work?

In its report, the CBO predicts the deficit will shrink again in a few years, but only if President George W. Bush's tax cuts expire at the end of next year and the government gets paid back from banks that got bailed out.

But even if policymakers manage to navigate successfully through the current recession and the trillions in new debt bring about the desired economic recovery, this is not a great time to raise the level of debt relative to GDP.

That’s because another multitrillion-dollar bill is coming due — no matter how well the economy recovers. As baby boomers retire and begin making claims on the Social Security and Medicare systems, the government will be forced to borrow heavily to meet those obligations. Unlike the surge that sent debt levels above GDP during World War II, that level of borrowing for decades of Social Security and Medicare payments just isn’t sustainable.

As the problem comes into clearer focus over the coming years, it could get more difficult to convince the rest of the world to lend their money to the U.S. Treasury. That could bring much more serious cuts in government spending, forcing major cuts in government services.

What could go wrong with the stimulus plan?

It’s not at all clear that a short-term burst in spending will create long-term economic growth. The first stimulus package last year, which included more than $100 billion in rebate checks, did little to stop the downward spiral.

It’s also not clear how the stimulus package will stem another surge in foreclosures that is just now getting under way. That new wave is expected to continue through next year unless something can be done to prevent it. As long as lenders keep dumping houses on the market at distressed prices, more home equity will be destroyed for all homeowners, spending will continue to shrink, jobs will be lost and the economy will remain in its downward spiral.

If the multitrillion-dollar bet pays off, there’s also a real risk of nasty side effects. For starters, there’s only a certain amount of hard money (savings and investment) around the world for Uncle Sam to borrow to make up for these massive deficits. As the U.S. soaks up this cash, there’s less money for businesses to borrow and grow or for homeowners to buy houses. That forces interest rates higher — reversing the stimulus effect the Federal Reserve is trying to engineer with lower rates.

Churning out more debt also increases the amount of dollar-based investments flowing through the global financial system. It’s not exactly the same as printing dollars, but the effect is similar. As the global system is flooded with dollars, and investors start wondering how Uncle Sam is going to pay all this back, the value of the dollar falls.

If it falls a little, that’s not a bad thing — it helps U.S. exporters sell goods overseas. But if the value of the dollar falls too far, so does its purchasing power even if demand for goods and services remains sluggish during a recession. That’s where inflation comes in. And if you have inflation in a recession, you get stagflation, the disease that left the U.S. economy and stock market in ruins throughout most of the 1970s.

This is an updated version of a story that originally appeared Jan. 5, 2009.

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