WSJ: In Debt Crisis, Uncle Sam Is Piling It On

From the 3/24/2008 issue of the Wall Street Journal comes this story written by Mark Gongloff.

While everybody else is running headlong from the burning building of debt, Uncle Sam looks like he is rushing in the other direction.

As the credit crisis deepens, there's every reason to expect old-fashioned Keynesianism to become de rigueur, with the government blowing out the budget to make the downturn less painful.

It started with the recently passed $152 billion stimulus package, and it probably doesn't end there. The government is also building massive backstops for the financial system and the housing market, agreeing to hold or guarantee trillions of dollars in mortgage and other private loans through the Federal Reserve, and, less directly, through federal home loan banks, Fannie Mae and Freddie Mac.

The next steps could be more stimulus, direct bank bailouts and government purchases of mortgage securities, easily dwarfing the $125 billion or so the government spent to fix the savings and loan debacle. The alternative could be a far more devastating economic downturn now.

Is the government in any position to take on this burden? At the moment, the federal budget seems to have wiggle room. The deficit shrank last year to 1.2% of gross domestic product, the lowest since the budget was in surplus in 2001. And the Congressional Budget Office projects surpluses will reappear in 2012.

But the CBO estimates aren't very realistic. They don't take into account the stimulus package, spending on wars in Iraq and Afghanistan wars (sic) or patches for the alternative minimum tax. Nor do they account for an economic slowdown that is already having an impact on federal tax receipts. Both corporate and personal non-withheld receipts turned negative on a year-over-year basis in the fourth quarter, according to Goldman Sachs analysts, who estimate the deficit will jump to 3% of GDP this year and in 2009 - double the CBO's forecast.

Meanwhile, presidential candidates of both parties are making promises that will cost trillions of dollars more if they keep them, either in expanded health-care coverage or making the 2001 and 2003 tax cuts permanent. More ominously, all of this comes as millions of baby boomers are on the threshold of retirement, which will lead to an explosion of Medicare and Social Security spending in the years ahead.

In theory, deficits push interest rates higher as government debt competes with private debt for investors' attention. A 2003 Fed study estimated that every time the budget deficit rises by one percentage point of gross domestic product, it adds one quarter of a percentage point to what long-term rates would otherwise be.

The budget has been in deficit for most of the past two decades with little noticeable impact on borrowing costs. This is largely because foreign investors, mainly central banks, have been happy to finance the profligate spending of U.S. consumers, lawmakers and presidents by snatching up Treasury bonds, keeping the rates low.

As long as they're willing to keep buying U.S. assets, this happy symbiosis can last. At some point, they might start to worry about America's ability to pay its growing debts.

Then Uncle Sam will ahve to start deleveraging, too.

Email mark.gongloff@wsj.com