The Sustainability of the Federal Budget Deficit: Market Confidence and Economic Effects

Marc Labonte
Specialist in Macroeconomic Policy

The budget deficit was more than $1 trillion or 9% of GDP in 2009 and 2010, and it is projected to be that large again in 2011. Combined with a shrinking economy, this increased the publicly held federal debt by over 20 percentage points of GDP between 2008 and 2010, and it is projected to increase it by another 7 percentage points in 2011. Deficits of this size are not sustainable in the long run because the federal debt cannot indefinitely grow faster than output. Over time, a greater and greater share of national income would be devoted to servicing the debt, until eventually the government would be forced to finance the debt through money creation or default.

Although the debt cannot persistently rise relative to GDP, it can rise for a time. It is hard to predict at what point bond holders would deem it to be unsustainable. A few other advanced economies have debt-to-GDP ratios higher than that of the United States. Some of those countries in Europe have recently seen their financing costs rise to the point that they are unable to finance their deficits solely through private markets. But Japan has the highest debt-to-GDP ratio of any advanced economy, and it has continued to be able to finance its debt at extremely low costs.

If investors on balance deemed the debt to be unsustainable, the yields and the cost of credit default swaps on Treasury securities would be expected to rise. Instead, both are currently low. This may seem surprising, given that the debt is currently growing more rapidly than output, and it is projected to continue to do so under current policy. Over the next few years, the deficit is projected to fall somewhat, but if tax provisions scheduled by law to expire are extended and discretionary spending stays at recent levels, the deficit would not fall enough under current policy to stabilize the debt, and it is projected to begin rising again later in the decade. Further, the debt is projected to begin rising more rapidly in the long term under current policy because of the rising costs of Social Security, Medicare, and Medicaid.

The willingness of bond holders to finance the federal debt at low interest rates in light of these projections suggests that they believe that policy changes will eventually be made to place the federal debt on a sustainable path. This belief could change at any time; if it did, the experience of foreign countries suggests that the effects on the economy and financial markets could be severe. A failure to raise the debt limit or a ratings downgrade of U.S. debt by a credit rating agency are two events that have been seen as potential catalysts for a change in investor sentiment.

Standard macroeconomic theory predicts that the large deficits have temporarily boosted overall spending at a time when there is significant slack in the economy. Once private investment demand recovers, a large deficit would be expected to “crowd out” private investment spending. By accounting identity, domestic investment spending equals national saving plus net borrowing from abroad. The budget deficit is currently more than half the size of private saving. Even before the increase in the deficit, national saving was insufficient to finance domestic investment spending, and the United States was borrowing from abroad at unprecedented rates, peaking at about 6% of GDP. (Borrowing from abroad has since fallen by half, but remains relatively high.) To sustain large deficits, the economy will require some combination of higher private saving, lower investment, and higher borrowing from abroad. Some economists have argued that borrowing much more from abroad is unrealistic, and the already heavy U.S. reliance on borrowing from abroad makes the maintenance of a large deficit even less sustainable.

This report will evaluate current concerns about the sustainability of the deficit, and what effects it will have on the economy.


Date of Report: June 28, 2011
Number of Pages: 19
Order Number: R40770
Price: $29.95

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