U.S. deficit reaches record $1.6-trillion

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Barack Obama has put a sobering price tag on the financial crisis and the ensuing recession - a record-shattering $1.6-trillion (U.S.) deficit for 2010.

The U.S. President unveiled his budget proposal Monday - a plan that juggles the conflicting goals of boosting the ailing economy in the short term, while tackling runaway deficits in 2011 and beyond.

For Americans, and the rest of the world, the cost of U.S. fiscal excess may be felt for years through higher interest rates, inflation and lower growth.

At 10.6 per cent of gross domestic product - the broadest measure of the economy - the projected deficit sets a post-Second World War record.

The good news is that economic calamity is not inevitable, according to economists. The United States can mitigate the damage of its deteriorating fiscal health by changing its ways now.

And Mr. Obama, speaking Monday as he unveiled his budget proposal, vowed to slay the deficit as the economy recovers and to treat taxpayers' money with respect.

"We simply cannot continue to spend as if deficits don't have consequences, as if waste doesn't matter, as if hard-earned tax dollars of the American people can be treated like Monopoly money, as if we can ignore this challenge for another generation," he said at the White House.

"We can't."

Mr. Obama projects that 2010 will be a high-water mark for the deficit.

From here on, the White House foresees both the deficit and the debt declining as a share of the economy. And by 2014-15, the deficit will equal a more manageable 3.9 per cent of the economy.

The President accomplishes this recovery, in part, with the help of an accounting trick well known to government - unusually rosy economic projections. For example, the White House expects the world's largest economy to grow 3 per cent this year, and more than 4 per cent in 2011 and 2012. That boosts projected tax revenues. But it's significantly more optimistic than the current consensus among private-sector economists.

Fortunately for the United States, the country was in relatively sound fiscal shape before the financial crisis and the recession blew a gaping hole in the deficit.

Even with another $1.6-trillion added to the country's debt load this year, the United States remains less indebted than many other developed countries, including the Eurozone and Japan. By the end of 2010, public debt in the United States will equal roughly 62 per cent of annual economic output. That's up from 50 per cent in 2008.

Europe, on the other hand, entered the crisis with a debt-to-GDP ratio of nearly 70 per cent. Japan is off the charts entirely, with a projected debt this year twice the size of its economy.

And by historic standards, the projected 2010 deficit is not unprecedented. The United States ran up annual budget shortfalls equal to nearly 30 per cent of GDP during the Second World War.

The key to reducing the debt is to break the pattern of ever-higher spending.

Unless the United States tackles the big-ticket budget items, the federal debt is on a course to reach 300 per cent of GDP by 2050, according to a recent study by the Washington-based Center On Budget and Policy Priorities.

And many economists aren't convinced Mr. Obama and Congress are committed to making the tough choices.

"The problem is that politicians like to cut taxes and increase spending, leading to much higher outlays than revenues," pointed out economist Augustine Faucher of Moody's Economy.com in West Chester, Pa. "The math is inescapable."

Mr. Obama's budget, for example, does not directly deal with the single largest contributors to the deficit - rising health-care costs and other government entitlement programs. Growth in the cost of Medicare, Medicaid and Social Security account for all the increase in projected federal spending over the next four decades. But Mr. Obama has vowed not to touch them.

Economists warned that the long-term effects of not reining in the deficit will be higher interest rates, slower growth and inflation.

That scenario may be tough to believe as most borrowers are now enjoying record-low interest rates.

Even White House budget director Peter Orszag acknowledged that interest rates have stayed low in part because demand for loans by everyone except the government has collapsed.

"The U.S. Treasury is basically the last borrower left standing," he said. "You want to make sure that you're getting ahead of the fiscal deficit problem so that you're not crowding out private activity."

But that's unlikely to last indefinitely. Late last year, a Treasury Department advisory panel warned that the yield on 10-year U.S. Treasury bills could spike to 10 per cent over the next decade as the debt swells. That would increase the cost of servicing the debt and lead to higher borrowing costs for consumers and businesses alike.

The other major impact of a runaway deficit is that it could act as a brake on economic growth. A new study by economist Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard University found that the critical threshold of debt-to-GDP for a country is 90 per cent. Beyond that point, debt corrodes economic growth.