Goodbye, Surplus

Spending on Iraq will push the total deficit for the fiscal year ending on Sept. 30, 2004, to at least $525 billion, according to Goldman Sachs Group Inc. The $5.6 trillion cumulative surplus the CBO once predicted for the 10 years ending in 2011 has disappeared. In its place is a 10-year deficit that the nonpartisan CBO estimates could reach $1.4 trillion. The plunge into the red raises tough questions for Bush and Capitol Hill lawmakers: Can the U.S. government afford to pay $87 billion during the next year keeping troops in Iraq -- and spend $400 billion during the next decade overhauling Medicare to provide prescription drugs for the elderly? Should it keep cutting taxes now -- or move to safeguard Social Security pensions for 76 million baby boomers who'll start retiring in 2008? Democratic presidential candidates have used the budget reversal to assail Bush's economic record. As the politicians stump, the National Debt Clock is ticking so fast that its last few digits blur.

Bonds Stumble

U.S. Comptroller General David Walker says the ballooning federal debt could imperil the U.S. economy by driving up interest rates.
After a three-year bull run, the bond market has turned skittish: In the sharpest decline since 1980, the price of 10-year U.S. Treasury notes fell 8 percent in July. As of mid October, investors in the $3.3 trillion Treasury market were headed for their first annual loss since 1999. Investors who bought $10 million of 10-year notes on June 16, when yields fell to a 45-year low of 3.07 percent, had lost about $845,000 on their investment by Oct. 27, when the notes yielded 4.28 percent. That's an 8.45 percent loss. With governments such as Germany's and Japan's facing gaping shortfalls of their own, the competition for global investors is intensifying.
``The idea that this is manageable, that we're going to grow our way out of the problem is just flat false,'' says Walker, who heads the nonpartisan General Accounting Office. In its relentless tally of federal obligations, the midtown clock understates the explosive growth of debt in the U.S. -- and the havoc this debt could wreak on the economy. The combined borrowings of U.S. households, nonfinancial businesses and federal, state and local governments ballooned to $21.6 trillion as of June 30 from $1.42 trillion in 1970, according to Federal Reserve flow-of-funds figures.

$33 Trillion

Add to that the borrowing by banks and financial companies -- which typically take on debt to make loans -- and the total rises to $33 trillion. As a percentage of gross domestic product, the grand total of U.S. debt outstanding, now 294 percent, exceeds the previous record of 270 percent set during the Great Depression. The U.S. debt surge worries Jane D'Arista, a director of the Financial Markets Center, a Philomont, Virginia-based nonprofit research institute focusing on the Fed and financial markets. ``It's like a tsunami wave,'' she says. As the federal red ink runs and interest rates rise, debt is squeezing average Americans harder than ever. More people filed for bankruptcy during the second quarter of 2003 than in any previous quarter in history. Personal bankruptcy filings jumped 7 percent to a record 430,926 in that period, bringing the 12-month total to a record 1.61 million, according to the American Bankruptcy Institute.

Delinquencies

At commercial banks, bad credit card loans totaled 5.9 percent of all credit card debt in June, eclipsing the peak of 4.9 percent reached after the 1990-91 recession, Fed figures show. Delinquencies in the $6.9 trillion U.S. home mortgage market rose in the second quarter to 4.62 percent, up from 4.52 percent in the first quarter, according to the Mortgage Bankers Association of America.
And still, consumers keep borrowing: $8.2 billion in August alone, according to the Fed.
Many U.S. corporations are nursing debt hangovers from the go- go '90s. Since 2001, financial markets have been roiled by seven of the 10 largest bankruptcies in U.S. history: WorldCom Inc., Enron Corp., Global Crossing Ltd., Adelphia Communications Corp., UAL Corp., Pacific Gas & Electric Co. and Kmart Corp.

`Bankruptcy Nationally'

Last year, defaults on high-yield, high-risk junk bonds -- those rated below Baa3 by Moody's Investors Service and below BBB- by Standard & Poor's -- rose to 10.8 percent of debt outstanding, a level second only to the record 12.8 percent reached in 1991, when the collapse of junk bond powerhouse Drexel Burnham Lambert Inc. collided with an economic slump. The default rate has since fallen to 6.7 percent, and borrowing has soared anew. The $4.23 trillion U.S. corporate bond market is having a banner year: During the first nine months of 2003, sales of new junk bonds totaled $100.5 billion, exceeding the $58.6 billion sold in all of 2002, according to Bloomberg data.
David Littmann, chief economist at Comerica Bank in Detroit, says skyrocketing government, corporate and consumer debt could one day send the U.S. economy into a tailspin. The Treasury could flood the bond market with new securities as it finances chronic deficits, pushing bond prices down and interest rates up. That could prompt investors to shun U.S. bonds, sending rates soaring further and the dollar plummeting, Littmann says. ``You're headed for a bankruptcy nationally,'' he says.

`Let Things Ride'

That's the extreme case. Rudolph Penner, director of the CBO from 1983 to 1987, says the government should avoid trying to cut spending and, in turn, the budget gap until the economy strengthens, even though some investors fret about the deficit. ``We should let things ride a bit,'' he says. When Bush was inaugurated in January 2001, the good times -- and surpluses -- seemed to stretch as far as forecasters could see. The longest economic expansion in U.S. history had left the federal government with an unprecedented windfall: a surplus of $236.4 billion in fiscal 2000.
Having campaigned on the promise of returning the surplus to voters in the form of a tax cut, Bush addressed a joint session of Congress on Feb. 28, 2001, and made his case. He said the projected surpluses would enable the government to cut $1.6 trillion in taxes, pay down the nation's long-term debt by $2 trillion and set aside $1 trillion for unforeseen problems -- all while funding necessary government programs. ``The growing surplus exists because taxes are too high and government is charging more than it needs,'' Bush told Congress that day. ``The people of America have been overcharged, and on their behalf, I'm here asking for a refund.''

Clock Restarts

Even as Bush spoke, the economy was sliding into recession -- and the surplus was beginning to evaporate. After growing for 31 consecutive quarters, the economy shrank 1.6 percent in the April- June period. That August, the CBO pared its estimate of the cumulative 10-year surplus to $3.4 trillion. A month later, the World Trade Center and the Pentagon were attacked. The recession and the effects of Sept. 11, coupled with $1.7 trillion of tax cuts, triggered the largest slide in government revenue in more than 50 years. In 2002, individual income tax receipts fell by $135 billion, or 13.5 percent, to $858.3 billion, according to the CBO. After four years in surplus, the federal budget slid into the red. That year, the Dursts, whose privately owned Durst Organization Inc. is one of New York's largest real estate firms, turned their debt clock back on. Peter Fisher, former U.S. Treasury undersecretary of domestic finance, says the deficit is no cause for alarm. Deficits come and go as growth ebbs and flows. And besides, even the best deficit forecasts are usually off by $100 billion or more, Fisher said in an interview shortly before leaving the Treasury on Oct. 6. ``I don't think the word crisis captures it,'' he said of the current situation.

Rubin Warns

Robert Rubin, Treasury secretary from 1995 to 1999, disagrees. Rubin -- who persuaded President Bill Clinton to pare the deficit in the 1990s by curbing spending and raising taxes -- has warned that the U.S. faces ``a day of reckoning.'' Speaking to reporters in Washington on Sept. 29, Rubin, now chairman of the executive committee at Citigroup Inc., said government bond sales threaten to crowd out the capital available for private industry and drive up 10-year Treasury yields by as much as 2.5 percentage points. Such an increase would lift 10-year yields, at 4.28 percent on Oct. 27, to 6.78 percent, a level not breached since 1997.
``These effects are hugely consequential, but the effects could be far more severe if the markets decide this fiscal imprudence is going to continue,'' Rubin said.

`Enormous Obligations'

Rubin is a member of the Concord Coalition, a bipartisan group that advocates for balanced budgets. He and other members -- among them, Peter Peterson, chairman of the Federal Reserve Bank of New York -- have urged the government to tackle the deficit, which is expected to equal 4.3 percent of U.S. GDP in fiscal 2004. The group says the federal deficit could eat up 6 percent of economic output by 2020, 12 percent by 2030 and 21 percent by 2040.
``There are enormous obligations on the books,'' says Robert Bixby, the Concord Coalition's policy director. The government needs to reduce the deficit before baby boomers start retiring or the burden will soar, Bixby says. ``If we go into that era running big deficits, the deficits will metastasize,'' he says. Even if Bush is right and tax cuts spur the economy and, in turn, government receipts, consumers must still confront their own record debts. Since 1998 alone, outstanding consumer and mortgage debt has jumped 57 percent, to $8.42 trillion from $5.36 trillion, Fed data show.

Unemployment

Consumers are now shouldering that burden through a season of falling household wealth and rising joblessness. The stock-market- fueled wealth gains of the late 1990s have faded; households' net worth has fallen to an average of 5.1 times disposable income from 6.26 times in March 2000, according to the Fed. Since Bush became president, the U.S. economy has shed about 2.5 million jobs. Not since 1929-33, when Herbert Hoover was in the White House, has a president presided over a decline in nonfarm jobs during an entire four-year term. The unemployment rate rose from 4 percent in January 2001, when Bush entered the White House, to 6.4 percent this past June -- the highest level since 1994, when Bill Clinton was president and the jobless rate had already declined from 7.8 percent in 1992. In September, U.S. businesses unexpectedly added 57,000 nonfarm jobs for the first increase in eight months; the jobless rate was 6.1 percent.

Growing Burden

During the 1990-91 recession, consumer borrowing fell 1 percent. In 2000, people kept borrowing even as growth stalled. Outstanding consumer debt rose 7.3 percent in 2001 and 4.3 percent in 2002.
Now, as bond investors drive yields higher, consumers' debt burden could grow. Today, the average U.S. household has six credit cards with a combined limit of $21,000, according to New York-based Demos, a nonpartisan public policy group. More and more Americans are flexing that plastic for no-frills items such as food, transportation and their children's education, often with catastrophic results, says Amelia Warren Tyagi, coauthor of ``The Two-Income Trap: Why Middle-Class Mothers and Fathers Are Going Broke'' (Basic Books, 2003), a book that examines the debt burdens of middle-income Americans.
It's easy to see how some credit card holders get into trouble. A gold MasterCard from Citigroup Inc.'s Citibank unit carries an annual percentage rate of 13.99. If a customer fails to make payments, however, the rate may jump to as high as 27.99 percent. Credit card late fees run as much as $35.

Paying Up

Issuers collected $7.3 billion in such fees in 2001, up from $1.7 billion in 1996, according to Cardweb.com, an online research service that tracks the industry. Paying on time is no quick fix: Making minimum monthly payments, it would take 30 years to pay off a $5,000 balance on a credit card with a 15 percent annual percentage rate.
Many Americans no longer save. From 1981 to 2000, the U.S. household savings rate slid to negative 0.8 percent of disposable income from 10.2 percent -- the first negative reading since the Depression, according to Hackettstown, New Jersey-based SMR Research Corp.
U.S. corporations, meantime, have only just begun to deal with their own debt hangover. Outstanding corporate debt climbed 8.8 percent to $4.98 trillion in the second quarter of this year from $4.58 trillion as of January 2000. During the 1990s, corporate debt outstanding rose 66 percent, Fed figures show. Paul Hanrahan, chief executive officer of electrical power generator AES Corp., is trying to kick the debt habit, after the company's soaring borrowing sent AES stock plummeting 81.5 percent in 2002. After defaulting on loans to Eletropaulo Metropolitana SA, Latin America's biggest utility, in August 2002, AES exchanged half of its $5 billion Brazilian business for loans from Brazil's government. The government subsequently agreed to reschedule $1.2 billion of AES debt, forgiving $600 million of it outright and extending payments on the remainder by a decade. ``We got ahead of ourselves,'' Hanrahan says.

Germany, Japan

As U.S. debt swells, the Treasury will have to compete with the governments of Japan and Germany for investors. German Chancellor Gerhard Schroeder faces a projected 15.6 billion-euro ($18.3 billion) budget shortfall in 2004 and wants to pay for tax cuts by selling 29 billion euros of debt. By the end of 2004, the German government's net financial liabilities are likely to rise to 52.4 percent of the nation's nominal GDP -- double the level of a decade earlier, according to the Organization for Economic Cooperation and Development.
In Japan, Prime Minister Junichiro Koizumi pledged to cap annual government bond sales at 30 trillion yen ($275 billion) and then broke his promise because of slumping tax revenue. Koizumi's government plans to sell 36.4 trillion yen of debt in the fiscal year ending on March 31, 2004. National debt accounted for 71.7 percent of GDP last year and will rise to 88.6 percent by 2004 -- a fivefold increase in the past decade, the OECD forecasts. The Concord Coalition's Bixby says rising government debt in Europe and Japan will make it tougher for the U.S. government to finance its deficits without offering bond investors higher yields. ``As other countries have their own debt problems, capital may stay in Europe and Japan,'' he says. ``We may find that it is not as easy to attract foreign capital.''

Buy Bonds

Paul Calvetti, head of Treasury trading at Barclays Capital Inc. in New York, says foreign investors will keep buying Treasuries because there's no chance the U.S. government will default on its obligations. Inflation is tame, and the Treasury market is the largest and most liquid bond market in the world, he says. ``There's always going to be someone who's willing to step in and buy them,'' he says.
Global investors have another incentive to buy Treasuries: higher yields already in place. In mid-October, 10-year Japanese government bonds traded at a yield of 1.35 percent; 10-year German government bonds paid 4.19 percent.

`Part of the Action'

William Sullivan, senior economist at Morgan Stanley, says the U.S. rate premium -- and the sheer size of the U.S. bond market -- ensures the Treasury will find buyers for its debt. ``This is the most liquid market on the planet,'' he says. ``There's no doubt foreign investors want to be part of the action.''
As the 2004 presidential campaign heats up, Democratic candidates have begun to criticize Bush for cutting taxes in the face of a gaping budget gap. ``It's reckless, and it's wrong,'' retired U.S. Army General Wesley Clark told Iowans on Oct. 6, as he campaigned for the Democratic nomination. Bruce Bartlett, a Washington-based senior fellow at the National Center for Policy Analysis in Dallas, says many Americans are more worried about finding or keeping jobs than they are about the mounting deficit. Democrats' budget warnings may not resonate with voters. ``Nobody's going to complain about deficits when unemployment is high,'' he says.

Here and Now

Like voters, presidents and lawmakers typically focus on the here and now -- and let their successors worry about the future. In the 1960s, President Lyndon Johnson launched Medicare and food stamps while waging a war in Vietnam. His failure to raise taxes to pay for those efforts led to accelerating inflation and set the stage for 1970s stagflation: the combination of slowing growth and rising prices. In the 1980s, Ronald Reagan's combination of tax cuts and military spending overwhelmed reductions in domestic programs. The federal budget deficit swelled from $74 billion in 1980 to $155.2 billion in 1988.
Under Reagan's successor, George H. W. Bush, the deficit rose to a then record $290.4 billion in 1992. Bush lost the 1992 election to Bill Clinton. While Clinton was in the White House, the deficit shrank steadily as economic growth increased tax revenue. Vice President Al Gore lost the White House to George W. Bush anyway.
Federal Reserve historian Allan Meltzer says leaders must muster the political will to fight tomorrow's deficits today. ``What we should be doing is not screaming about the deficit being $450 billion or $500 billion but worrying about future deficits -- and what we can do to avoid them,'' he says. In the meantime, above Sixth Avenue, the National Debt Clock tallies the bill for future generations.