Rising deficits and the risks in the US economy

The US Congressional Budget Office (CBO) has estimated that the White House’s tax and spending plans would create deficits totaling $2.3 trillion more than the president’s budget projected for the next decade. This coupled with the looming deficits in Medicare and Social Security, makes the medium and long term propsects for American budget balance bleak.

While the Obama budget predicts total deficits for the next decade of nearly $7 trillion, the CBO estimates it to be nearly $9.3 trillion. The annual deficits for much of the next decade are estimated by the CBO to be in the range of 4-5% of GDP, an unsustainable figure. The budget projections are based on the optimistic assumptions that the economic recovery would bring in enough revenues to cover up the accumulated deficits of the next couple of years.

As Roger Lowenstein puts it in persepctive, "over the past half century and regardless of the party in power, federal tax receipts have usually provided 80 to 90% of the money needed to fill the budget; thus, the government has had to borrow only the remaining fraction. But this year, it will need to borrow 45% (assuming a deficit of $1.75 trillion), virtually half, of what it is projected to spend."

The sharp rise in the prices of the 30 year US Treasury Bonds, reflected in the fall in yields below 3%, and warned as a possible speculative bubble by Warren Buffet, is in many ways a reflection of the long term risk perception of the US economy. The Treasuries reflect the full faith and credit of the US government and its economy, and has for long been considered the ultimate "risk-free" investment. But the global credit crunch and spiralling counter-party risk perceptions which drove global investors (and especially emerging market Central Banks) to flee to the relative safety and liquidity of the US Treasury Bonds, driving up their prices (and their yields to post-Depression lows), have cast serious doubts about the "risk-free" assumption.



These T-Bond sales have been financing the burgeoning US deficits, and the low yields have helped the Obama administration sustain its stimulus spending plans. But, as Mohamed El-Erian, chief executive of the bond house Pimco says, were the Fed to absorb surplus Treasuries, the government would, in fact, merely be "printing money", with the attendant dangers of a textbook case of inflation and erosion in the real values of the T-Bond investments as the economy rebounds.