U.S. deficit impact could be felt for decades

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.

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