A federal deficit occurs when the government's expenditures for the year exceed its income. The government then pays for those excess expenditures by borrowing money, adding to the national debt. After a brief period of budget surpluses, the federal government is again running up substantial budget deficits. Are these deficits a cause for concern? It's tough to decide, since opinions range from they don't matter at all to they will ultimately result in federal bankruptcy. It might help to put the federal deficits in perspective.
In 1998, for the first time in 28 years, the federal government ran a budget surplus. Those surpluses lasted for four years. During that time, concerns about the viability of the Social Security system seemed less urgent, and there was talk about what would happen to the bond market if the federal government paid off all its debt. These concerns were short lived. Following two tax cuts, the September 11 terrorist attacks, the Afghanistan and Iraqi wars, and a recession, the federal deficits were back.
The fiscal year 2004 (the government's year-end is September 30) budget deficit was $412 billion, while fiscal year 2005 is expected to be in the $325 to $350 billion range (Source: Associated Press, July 8, 2005). A recent Congressional Budget Office report projects federal deficits over the next 10 years to total $3.5 trillion.
Of course, a federal deficit results in an increase in the national debt. As of July 18, 2005, the national debt was $7.855 trillion. A significant portion of that debt is owed to the Federal Reserve and other government accounts. As of March 2005, the public held 59% of the national debt (Source: U.S. Treasury Bulletin, June 2005).
While the dollar amounts of the current and projected deficits and national debt are enormous, these numbers are often presented as a percentage of gross domestic product (GDP) to show that they really aren't out of line with past deficits and debt levels. For instance, in 2004, the deficit as a percent of GDP was 4.5%, which was not dramatically out of line with past figures. But does that mean that we don't need to be concerned about the deficits or the level of the national debt? Some of the more significant concerns include:
Higher interest rates
Deficits are generally believed to increase interest rates, due to their impact on the supply and demand for loanable funds. Deficits reduce national saving, causing interest rates to rise and investment to fall. A 2003 study by a Federal Reserve economist found that a one percentage point increase in the projected deficit-to-GDP ratio was estimated to increase long-term interest rates by .25% (Source: Federal Reserve Bank of San Francisco, 2004).
Interest payments on the debt
During periods of budget deficits, the national debt increases every year. Thus, even if interest rates remain constant, interest costs will increase. But interest rates do not remain constant and are now increasing. Thus, interest costs will increase due to a general increase in interest rates and an increase in the total amount of debt.
For fiscal year 2004, interest was the sixth largest expenditure by the federal government, accounting for 6.7% of total expenditures (Source: Council of Economic Advisors, 2004). And that was during a period of very low interest rates. One study looked at what would happen to interest costs if the effective interest rate on the national debt rose from 3.54% in mid-2004 to the average level of 6.36% for the period 1992-2001. That increase would cause interest expenditures to rise to the fourth largest government expenditure and would likely move to third place, behind Social Security and national defense, if debt levels increased as well (Source: Business Economics, January 2005).
The government's ability to contain spending
While projected budget deficits of $3.5 trillion over the next 10 years seem overwhelming, there are concerns that the deficit could exceed even those figures. For instance, the projections do not include the costs of additional Medicare benefits that were recently enacted. Also, these estimates are based on an assumed GDP growth rate of 4.62% per year for the entire 10-year period, an event that has never occurred before in U.S. history.
What impact on our economy will deficits of this size have if they continue into the future? No one knows for sure. For years, we have heard dire predictions about how difficult it will be for future generations to fund Social Security and Medicare benefits for the baby boomer generation. It may be even more difficult if, leading up to this time, we have years of budget deficits rather than budget surpluses.