The Deficit Endgame

In 2009, the federal deficit will be 13 percent of GDP. This is the highest it has been since the four year period during World War II, when deficits averaged about 20 percent of GDP. The long-term budget outlook is equally troubling. The CBO projects that under the Obama Administration, the cumulative deficit for the period 2010-2019 will be approximately $9.1 trillion. In other words, the average deficit per year will approach $1 trillion. In adjusted estimates, we project the deficit under more realistic assumptions, and also factor in the possible costs of health care reform. Our adjustments add at least another trillion dollars to budgetary costs over the next ten years-a total deficit of nearly $10.2 trillion.

Countries with deficits this high have historically proceeded down three divergent paths. Some have chosen fiscal consolidation, others have chosen to attempt to inflate away the debt, and others have simply defaulted, if not intentionally, because of the failure to pursue either of the first two strategies.

In this paper, we discuss the historical evidence along each of these three paths, and compare the current U.S. situation to past experiences. We find that the most successful policy responses to high deficits have mimicked that adopted by the U.S. following World War II, that is, successful consolidations have generally reduced spending. Failure to do so exposes the U.S. government to significant default risk that could, if history is a guide, emerge as a factor in financial markets without significant notice.

Click here to view the full text of this working paper as an Adobe Acrobat PDF.

Kevin A. Hassett is a senior fellow and the director of economic policy studies at AEI. Desmond Lachman is a resident fellow at AEI. Aparna Mathur is a research fellow at AEI.

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Aparna
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