The US government has been running deficits almost continuously since 1970.[1] So we’re used to them. Things even started to look like they were improving during the late 1990s. Hi-tech industries went through a rapid run-up in value. This produced a lot of extra tax revenue without anyone complaining about it. Bill Clinton left George W. Bush a budget surplus of $236 billion in 2001. By early in 2002 the government was back in deficit by $150 billion.[2]

What we’re not used to are the immense deficits of recent years: the 2009 deficit was $1.4 trillion, the 2010 deficit was $1.56 trillion.

Where did these gigantic deficits come from? They came from a combination of the Bush-era tax cuts with a massive expansion in government spending. Some of the spending could have been avoided: the Iraq war and the Medicare prescription drug benefit proposed by President Bush and passed by Congress in 2003. Some of the spending could not be avoided: enhanced national security after 9/11, the invasion of Afghanistan. However, the biggest source of the deficit is related to the 2007-2008 recession. On the one hand, tax revenues fell during the slow-down by $400 billion (17 percent of revenues). On the other hand, the government pumped money into the economy: $154 billion for the TARP under the Bush administration and $202 billion for the stimulus bill under the Obama administration. That is a total of $756 billion added to the deficit without even counting the lost revenue from years after 2007.

Things got better as the recession ended: government revenue rose while spending fell. Soon, things will get worse again. According to Congressional Budget Office (CBO) forecasts in January 2015, the deficit will start to rise in 2017 as the costs of Social Security, Medicare, and Medicaid increase.[3] The CBO projects that deficits will bottom-out at $467 billion in 2016. Then deficits are projected to rise: $486 billion in 2017; $953 billion in 2023; over a trillion dollars in 2025. The real burden of these rising deficits will depend on the growth of the economy. Here again, the CBO has bad news: projected growth rates for 2014-2018 are at 2.5%, while those for 2020-2025 will fall to 2.2%.

How large a share of the Gross Domestic Product (GDP) will be represented by the deficits? Between 2016 and 2025, Social Security will rise from 4.9% to 5.7% of GDP; health-care spending will rise from 5.3% to 6.2%; and paying the interest on the debt will rise from 1.5% to 3.0%. Discretionary spending—everything else—will fall from 9.2% to 7.4%.

Still, the absolute dollar amounts don’t matter. Ratios between debt and GDP do matter because it is the ability of the underlying economy to support the debt and maintain the credibility of the government’s ability to service the debt that makes deficits supportable. The 2009 deficit amounted to 10% of GDP and the total debt amounted to almost 100% of GDP.

Why does this matter? The government has to borrow the money from private lenders in order to cover a part of our national expenses. IF there is a fixed pool of private savings (capital) from which to borrow, then expanding government borrowing reduces the amount of capital that is available for all other borrowers. (Capital in-flows from the rest of a troubled world can off-set this in large measure–in the US.)  People investing in business or buying homes will compete with the government. The government can and will pay whatever interest rate it needs to in order to not go bankrupt. As a result, interest rates will go up and the total pool of capital available for private investment will go down. Capital is one of the factors of production determining the state of the economy. High interest rates slow down the economy.

[1] “Deficits as far as the eye can see,” The Week, 16 April 2010, p. 11.

[2] So the Bush tax cuts cost the United States Government about $400 billion a year in revenue.

[3] Jonathan Weissman, “Budget Forecast Sees End to Sharp Deficit Decline,” NYT, 27 January 2015.