Federal Shortfall To Double This Year
Next President To Inherit Deficit Of $500 Billion

By Lori Montgomery
Washington Post Staff Writer
Wednesday, September 10, 2008

A weak economy and a sharp increase in government spending will drive the federal budget deficit to a near-record $407 billion when the budget year ends later this month, and the next president is likely to face a shortfall in January of well over $500 billion, congressional budget analysts said yesterday.

A deficit of that magnitude could severely constrain the next administration's agenda, regardless of whether Sen. John McCain (Ariz.), the Republican candidate, or Sen. Barack Obama (Ill.), his Democratic opponent, wins in November. Each has promised billions in new tax cuts or new spending. The expanding deficit also will increase the national debt and could impair future economic growth, particularly if lawmakers are forced to pay down that debt by raising taxes.

This year's deficit will be more than double last year's $161 billion, and it will rise from 1.2 percent of the gross domestic product to nearly 3 percent. If the next president extends some or all of President Bush's signature tax cuts, as both candidates have promised, annual deficits could balloon to as much as 5 percent of the economy, rivaling the dark fiscal days of the early-1990s and those of the Reagan administration, said Peter Orszag, director of the Congressional Budget Office.

The budget picture is likely to grow even bleaker once government analysts factor in the anticipated costs of the Treasury Department's decision last weekend to take over struggling mortgage-finance giants Fannie Mae and Freddie Mac.

Orszag declined yesterday to attach a price tag to the takeover, under which Treasury Secretary Henry M. Paulson Jr. has pledged to invest as much as $200 billion to keep the companies solvent. However, Orszag said Paulson's action has bound the government so tightly to the two companies that he will incorporate them directly into the federal budget when he reexamines the nation's fiscal picture in January.

The massive companies, which together hold or guarantee about half the nation's 12 million residential mortgages, claimed more than $1.5 trillion in debt at the end of the second quarter. Because that debt is backed by a nearly equal amount in assets, Orszag said it will not significantly increase the nation's indebtedness.

Orszag said it was also unclear how the takeover will affect the annual budget deficit. Government accounting methods do not reflect the risk inherent in assuming control of billions of dollars worth of mortgage-backed securities in the middle of the worst housing bust since the Great Depression. As a result, budget analysts said it is possible that the takeover could add tens of billions of dollars to the deficit -- or little to nothing.

"One of the ironies of what we're experiencing is the shortcomings in the way in which the federal government currently accounts for credit transactions. When you engage in actions that do contain risk, it can look like there's a profitable opportunity because the system does not reflect the cost of risk," Orszag said.

The complex question of how to value the companies and their assets on the government's books will be decided in coming weeks. Meanwhile, the White House budget office has yet to decide whether to follow Orszag's lead and fully incorporate the companies into its budget, an act that could increase the perception of complete government control.

Regardless of the White House's decision, the government's underlying financial condition is likely to get worse, an administration budget official said. "Treasury will still have to raise money to keep these guys whole," the official said, speaking on condition of anonymity in order to speak candidly. "We will be spending money on these companies. It would be hard to say we're going to make money on this."

On Capitol Hill, lawmakers were less focused on the implications of taking over Fannie Mae and Freddie Mac than on casting blame for the rapidly rising deficit.

"This is a doubling by the Democratic Congress, and Congress controls the purse strings," said Sen. Judd Gregg (R-N.H.).

Democrats called that assertion preposterous, noting that much of the increase was the result of measures that received strong Republican support: one to return billions of dollars to taxpayers as part of the economic stimulus package and another to increase war funding. Bush signed legislation this summer to pay for the wars in Iraq and Afghanistan through the rest of his presidency, bringing total Iraq spending to more than $650 billion and the total for Afghanistan to nearly $200 billion.

"So they're fully responsible for the increase in the deficit," said Senate Budget Committee Chairman Kent Conrad (D-N.D.). "All of this happened on their watch, under their president."

In January, congressional budget analysts had estimated the deficit would be only $219 billion by year's end. By July, however, the White House was predicting that the number would spike to $389 billion because of new spending. Yesterday, the congressional analysts upped it even further, saying the increase over 2007 had been driven equally by two factors.

The weak economy has clobbered corporate profits, halting the growth of tax collections. And spending has jumped sharply, in part because of tax rebates, as well as a hike in expenditures to cover unemployment insurance and deposits of insolvent financial institutions.

This year's deficit will rival the record of $413 billion set in 2004. With the economy expected to remain sluggish for at least the next several months, the Congressional Budget Office projects that next year's deficit will rise to $438 billion. But Orszag said that number could easily climb to $540 billion if Congress acts in the coming months, as expected, to restrain the growth of the alternative minimum tax and to extend a variety of expiring business tax breaks.

Despite the gloomy budget outlook, Democrats said they would press ahead with plans for a second stimulus package of about $50 billion, a proposal opposed by Republicans but supported by Obama. "We would probably be in a worse situation if we didn't do a second stimulus," said Sen. Charles E. Schumer (D-N.Y.), who heads the Joint Economic Committee.

Economic advisers to the presidential campaigns said the big deficits would do little to change their plans for cutting taxes or, in Obama's case, for increasing spending on priorities such as health care and education. "A weak economy is not the time to dramatically reduce your budget deficit," said Jason Furman, an adviser to Obama, who wants to extend some of Bush's tax cuts. "The top priority is creating jobs and getting the economy going again."

Douglas Holtz-Eakin, an economic adviser for McCain, acknowledged that the deeper budget hole will make it much harder for McCain to keep his promise to balance the budget while extending all of Bush's tax cuts. "But that doesn't mean the first and best thing to do is raise taxes," Holtz-Eakin said. "The best thing to do is get the economy going again and create jobs."

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