FAQs: What does a trillion-dollar federal deficit really mean?

From Daniel Gross of The Upshot on Oct. 15:

On Friday, the Obama administration reported that the federal budget deficit for Fiscal Year 2010, which ended on September 30, came in at about $1.294 trillion.

In light of that information, a few FAQs:

How does this compare with past deficits?

It's huge. That's down from the record $1.4 trillion deficit in Fiscal 2009. But it still represents the second-largest deficit in history. In 2007, the deficit was only about $160 billion.

Can we afford to service this debt?

As is the case with mortgages, it's not so much the amount of debt you carry but the interest rate you pay that determines whether national debt is affordable. Interest rates have fallen rapidly in the past two years, and the government issues a lot of short-term debt. Last week the Congressional Budget Office estimated that the government spent $228 billion on interest alone in Fiscal 2010. That's about what the government spent on debt service in Fiscal 2006, when the national debt was significantly smaller.

Why was the deficit smaller in fiscal 2010 than it was in fiscal 2009?

As the economy began to grow again, the amount of revenue the government collected grew for the first time since fiscal 2007 -- by between 2 and 3 percent. Sharply rising corporate profits led to a large increase in the amount of corporate income taxes collected. Government expenditures fell for the first time since 1948.

Is the deficit "cyclical" or "structural"?

It's both. It's structural because, in the years before 2008, the system of taxes in place didn't collect enough money to pay for spending. Spending rose significantly in part thanks to the passage of the Medicare prescription drug benefit, the cost of waging two wars, and rising discretionary spending.

But cyclical factors — i.e. temporary factors related to the overall economic climate — exacerbated the structural deficit. When the economy falters, tax collections fall as corporate profits fall and the economy loses jobs, and expenditures on things like food stamps, Medicaid, and unemployment insurance rise. In 2008 and 2009, the U.S. suffered an extreme version of this cyclical condition. In fiscal 2009, revenues fell a stunning 16.6 percent.

The economic crisis also spurred extraordinary spending on initiatives like the TARP and the stimulus. And so in fiscal 2009, spending rose 17.9 percent. If revenues in fiscal 2010 had simply been even with the levels of 2007, the deficit would have been under $900 billion.

What does it mean for President Obama and the Democrats?

Not much good. The electorate doesn't seem poised to give President Obama and the Democrats much credit for reducing the deficit in fiscal 2010. For better or worse — mostly for worse — Obama and the incumbent Democrats now own the economy and the deficits politically.

The two options for reducing the deficit — slashing spending or raising taxes significantly — would likely cut into economic growth, thus dimming President Obama's chances for re-election in 2012.

What does it mean for Republicans?

Not much good, either. Republicans hope to recapture the House in November, which puts them in a position to be much more involved in the budget-making process. They've spent the last two years denouncing the rising deficits as a threat to America's economic well-being. But in order to extend all the existing tax cuts, they'll have to advocate for either (a) deficits that are as large or larger than the current ones; or (b) propose draconian and unpopular spending cuts.

What does it mean for you?

So far, not much. In theory, the existence of large deficits puts pressure on interest rates to rise and has the potential to ignite inflation. But interest rates have remained extraordinarily low, in part because the Federal Reserve has kept short-term rates near zero and investors fretting about uncertainty have parked cash in Treasury bonds. If signs of sustainable economic growth materialize, that could change. As Mark Zandi, chief economist at Moody's Analytics, told the Associated Press: "If we get to 2013 and policymakers don't look like they have a credible plan to deal with the deficit, then interest rates are likely to rise significantly and that will jeopardize the recovery we have under way at that time."

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