Drowning in debt: the long-term cost of the crisis

April 28, 2009

John Kemp Great DebateThe cost of bank rescues and fiscal stimulus is the largest financial disaster to befall the federal government in peacetime history of the United States.

Only World Wars One and Two, and the American Civil War, caused larger deteriorations in the budget. Bank rescues, stimulus and tax cuts will bequeath a massive legacy of government debt, on course to reach a level not seen since 1947.

Stabilising government finances will require deep cuts in spending and sharp tax rises in the years ahead.

The need to refund the huge stock of maturing debt and issue new securities to cover deficits will also make it hard for the Federal Reserve to raise interest rates in a timely manner once the crisis has passed. Officials will face a protracted conflict between raising rates to head off inflation and keeping them low to stabilise the government debt market and contain government borrowing costs.


All the challenges now facing the Fed, Congress and President Barack Obama were prefigured by President Franklin Roosevelt in his annual budget message to Congress in January 1942, when the president outlined the enduring financial consequences of mobilising the government and the nation to fight a “total war”. Click here for pdf.

Roosevelt promised to finance as much as possible of the cost through increased taxes. But the president recognised as much as two-thirds of the burden would have to be met by borrowing on an unprecedented scale.

He warned federal debt would rise from $43 billion in 1940 to 110 billion in 1943. In fact it rose six-fold from $43 billion in 1940 to peak at $269 billion in 1946. He also warned taxpayers would still be paying for the conflict long after the fighting was over: “an increase in interest requirements will prevent us for some time after the war from lowering taxes to the extent otherwise possible”.

How the government handled the challenge provides useful lessons for policymakers handling the legacy of debt from the current crisis.


The attached chartbook puts the bank rescues and fiscal stimulus in context. It shows the government’s annual borrowing, debt stock and interest payments since the 1930s, together with projections based on the budget plan submitted to Congress by the Obama administration and evaluated by the non-partisan Congressional Budget Office (CBO).

The budget deterioration between 2007 (when the government was running a deficit of 2.4 percent of GDP) and 2009 (when the deficit is forecast to hit 13.1 percent of GDP) is only half the size of the deterioration between 1940 (1.6 percent deficit) and 1942 (21.8 percent deficit) but far greater than anything experienced in peacetime.

Crucially however, wartime deficits were quickly reversed. The deficit shrank from 23 percent of GDP in 1945 to 2.8 percent of GDP in 1946, and by 1947 the federal government was actually running a small surplus of 1.7 percent of GDP. By reducing borrowing requirements and even running surpluses the Roosevelt and Truman administrations helped limit the build up in debt and maintain confidence in the government bond market.

In contrast, the Obama budget plan assumes the government will still be running deficits throughout the forecast horizon. The president’s outline has no plan to stabilise the long-term financing requirement, let alone run surpluses to pay down debt. Projected deficits in 2011 (6.4 percent of GDP), 2013 (4.1 percent of GDP) and 2019 (5.7 percent of GDP) are all much larger than before the crisis began and the budget position will be deteriorating again.

By failing to give investors a credible horizon for stabilising then reducing borrowing, the administration may struggle to place the securities it needs and risks triggering a sharp rise in yields once the immediate crisis has passed.

The Treasury is already running into resistance. Almost all the new debt issued so far has been short term (maturing in less than two years). The government has found it impossible to place longer-dated notes and bonds at acceptable yields; most medium and long-term securities have in effect been bought by the Federal Reserve (“monetised”) under the quantitative easing programme.


The Roosevelt-Truman administrations were able to turn deficits into surpluses because the wartime emergency was accompanied by a massive expansion in the tax base — and many of those taxes were maintained at or near emergency levels for several years after the conflict ended. The war was accompanied by a massive increase in “tax effort” (tax collections rose much faster than GDP as a whole).

In fact, the federal government was able to fund about a third of the cost of the war effort ($90 billion per year by 1944) through increased taxation ($32 billion) with remainder raised by borrowing ($62 billion). Once the fighting ended, extra revenues could be used to fund an expansion of social programmes as well as reducing government borrowing needs.

The problem with the Obama outline is that it is not accompanied by any increase in “tax effort” and fails to identify new sources of funding to rebalance the budget in the longer term. Officials argue that dealing with the crisis is a one-off expense which should be funded by borrowing rather than (deferred) tax rises. But the CBO projections show much of the deterioration is in fact structural and will not be reversed by current tax and spending policies.

The president’s budget will still require massive tax increases, spending cuts or some mixture of the two to bring the budget back to a more stable trajectory. It is silent on where these will be found. But the scale is reasonably clear. Even after current emergency programmes expire, the government will need to find tax rises or spending cuts amounting to around 2-3 percent of GDP by 2015-2019, which would represent one of the largest fiscal “consolidations” on record.


The debt build up will not be costless. Even assuming the government can hold costs to low levels, interest payments are set to climb from $237 billion per year in 2007 (1.7 percent of GDP) to $733 billion per year in 2019 (3.8 percent of GDP).

Interest payments were already the sixth-largest item in federal spending in 2007, absorbing 9 percent of all outlays. By 2019, interest payments will have risen to 11 percent and become the third or fourth-largest item. If debt cannot be stabilised, or borrowing costs rise, there is a real risk that rising interest charges will start to crowd out the money available for other programmes.

This will also create a severe problem for monetary policy. As in the late 1940s, the Federal Reserve will come under intense pressure to keep rates low and stable to avoid destabilising the bond market and triggering a damaging rise in yields that would drive up the borrowing burden significantly.

The Fed’s role as the government’s debt manager (assumed during the war and again during the recent crisis through the quantitative easing programme) will make it hard to raise rates.

After the war ended in 1945, the Fed found itself trapped, obliged to continue supporting the government bond market throughout the rest of the decade to avoid a damaging escalation of yields. Support was not withdrawn until the Fed-Treasury Accord in 1951 and not fully until 1953.

For all their promises that liquidity will be reduced and interest rates normalised in a timely fashion this time around, the debt overhang inherited from the crisis will pose the same dilemmas, and Fed officials will struggle to control liquidity and raise rates in a bond market characterised by massive (over-) supply.


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Peacetime? We’ve got two wars going on, genius. You can thank Bush for that.

Posted by Reynold Olson | Report as abusive

“Stabilising government finances will require deep cuts in spending and sharp tax rises in the years ahead.”

-and high inflation…

Posted by yr | Report as abusive

What’s worse is the fact that while the debt increase can be almost guaranteed, the growth (or even maintenance) of the GDP cannot. It is so positively foolhardy and naive to be sure that you will be making the same money tomorrow as you are today, and a nation is no different. This article is very right in its criticism, but I’m surprised that this point is so consistently overlooked. You think the debt is a problem now? Think of the higgly-piggly that will come out of it if our economy goes into a prolonged period of GDP reduction.

What’s that? Oh, right… that couldn’t happen here.

Posted by Russ in PA | Report as abusive

The US is not currently in/experiencing “peacetime”; Although we are not in the middle of WW3, yet, we are engaged actively in war in two countries at this very moment.

Posted by Tina | Report as abusive

Republicans are mad as hell, and they’re not going to take it any more. The problem is they don’t quite know what “it” is yet. If taxes are raised, that will be the rallying cry they need to regain a foothold, so taxes will not increase. (The new leadership has in fact decreased taxes with the $600 federal tax credit.) So what other method of financing is there? Could it be inflation? Why not, we haven’t done that in a while, and we could surely pay off at least half of the debt with a good round of it. All we have to do is inflate the dollar down to 50 cents and then pay back the debt with 50 cent dollars.

Posted by dp | Report as abusive

if i am reading your assumptions correctly, none of the borrowings for the bank bail-outs will be repaid to the federal government. that would mean that all banks which have borrowed from the government will fail to pay. or, to put it another way, they will all be bankrupt or are already bankrupt and, despite announcements to the contrary, cannot repay the government.

so, if our banking system is bankrupt, we should stand aside and let it fail? we are in worse shape than even i imagined.

Posted by bernborough | Report as abusive

“Stabilizing government finances will require deep cuts in spending and sharp tax rises in the years ahead.”

See there is the flaw in your story and the flaw that every pundit griping about the stimulus package has.

When has a politician EVER been elected for saying that they are going to increase taxes sharply? If they campaign on that promise they will never get elected. It’s not going to happen folks.

Good thing the Chinese didn’t have a pow wow with the American Indians before extending this massive credit line to the good ole USA. No doubt they have some stories about how well Americans keep their promises.

Posted by bob | Report as abusive

We are not currently in ‘peacetime,’ Mr. Kemp. We are fighting two wars, one in Afghanistan and one in Iraq.

Posted by Sean | Report as abusive

This author is the same who in previous columns was calling for inflation as the Governments method of escape for budget excess.

What gives? Why the sudden deficit hawk?
According to you previously, we merely inflate away the problem.Voila,problem solved.

You can’t have your cake and eat it too sir, either stand by your opinions or be relegated to oblivion.

Posted by Terry | Report as abusive

All the parameters needed to push our country deeper into socialism are being set in place. The time will fast approach when any incentives for fruitful labor will dissapear and we can then live off each other like a vat of slimy leaches. You can only redistribute someone elses wealth and penalize success to certain limits. It’s shameful that those we keep electing year after year to represent us in fact represent mainly themselves and their blind quest for power and fortune at the expense of a system that has flourished for two centuries but seems destined to take a similar decline as the Roman Empire…

Posted by William Maxfield | Report as abusive

The Free Trade Agreements which the USA negotiated over the last decade or so seemed to assume that the US economy would benefit from gains by US financial services, intellectual property licensing, and retail market control. In addition, the US got cheaper manufactured goods, and lower wage income, and lower inflation than “Made in the USA”.
ie: the “head-office” “value-added” in NE USA, and the dirty, dangerous factories in China, Mexico, Brazil, etc.
The consequences can now be assessed. It seems the USA does not only have a deficit problem, it also a major problem with income from the global economy – the trade deficit.
A bit like a bank employee in debt, borrowing more to cover the current problems, but now out of work, and trying to get some income from fruit picking.

Posted by Survivor? | Report as abusive

Hmmm lets see… maybe you should talk lessons from more recent wars that sank the economy. Seems if the wealthiest pay the lowest percentage in taxes and middle class pays for a completely idiotic war and corporate profits soar [especially “defence” contractors] usually less money ends up kicking around. If you wag your finger at someone maybe you should look at the past 8 years and not so much at the guy who’s been handed a pile of crap to turn back into gold!

Posted by peter Ketels | Report as abusive

I have to say, there are a number of men and women in active duty in the United States military who would be quite enraged to read the headline and first paragraph of this article

Posted by Adam | Report as abusive

A very good article. I would also add that the forward GDP growth figures given by the Obama administration are highly unrealistic. This will have a significant negative impact on debt. Also, as unemployment rises and companies go bust it means less tax revenue.

As you have said before one way of lessening this problem is via high inflation. I suspect that this is the only option. At the moment Obama is the Mesiah and we have a major economic pumping operation in progress. We are being told to spend and that all will be okay. Fine, but within two years the real problems, as detailed in your article will come to the fore.

It will be interesting to see how this pans out.

Posted by D Rumsfeld | Report as abusive

you didn’t mention Medicare, Drug plan and Social Security for 80 million boomers. I scanned to double check for that. isn’t that another little thing to think about when discussing public finances? the US governemnt uses shoe box accounting, as any CPA knows or will tell you, all of the above is “off the books” yet the dependency ratio, as desirable as the US is versus other developed countries, still applies in the great old USA as well.

Posted by Steven | Report as abusive

Interesting article, thanks. Two points:
– The US war effort in WW2 was massive relative to the economy and population size and enjoyed widespread popular support. Current military activities are tiny by comparison and do not enjoy the same degree of support. The current crisis emanates from the financing sector, not military activities. So, you are right to treat the current crisis as a peacetime rather than a wartime type challenge. Accordingly, the collective effort to face the sacrifices and master the recovery will be much harder to achieve.
– The vast ($60 trillion) future unfunded U.S. government liabilities from social welfare and medicare start to unwind over the next decade. If the U.S. government cannot reduce its net current liabilities over that period, then it will face an impossible task over the following years as these unfunded liabilities explode. May sound a long way away but markets will get nervous about this long before. The U.S. has perhaps five years to get the situation under control but the Fed’s projections do not see this happening. If the economic recovery is weak, there is less time and future prospects are bleaker. Thus, the Budget Office has already negatively revised its estimates on social welfare out to 2015.

In short, a national will not seen since WW2 is necessary to face harsh fiscal medicine and avert disaster later.

Posted by Simon Smelt | Report as abusive

if this is peacetime, id hate to see what war is like. this article is very oversimplified, neglectful, and excuse me but you get paid to write this stuff?

this is nothing new, stop writing like you are breaking facts! because your not! in-fact your avoiding them! (like how much the war, that you don’t acknowledge, is costing taxpayers) good job buddy.

Posted by frank | Report as abusive

The financial market meltdown has produced the most “unconventional” reactions by governments in the history of capitalism.

James refers to the “quantitative easing programme” as though it is nothing really extraordinary when in fact it is completely incomprehensible.

“QE programme”
1. Government issues long dated debt securities that are bought by investors who pay cash for them. Holding government Bonds is supposedly creme de la investment.

2. Severe contracting of government revenue (fiscal crisis) leads to forecast that there is a possible sovereign debt default looming that will require a severe reduction Government expenditure.

3. “Solution: implement QE by adding zeros to the central bank balances and use this computer generated “money” to BUY BACK the long dated Bonds that investors paid cash for.

4. Issue new short dated Bonds and get supplied with more cash from the investors that have just been paid back “computer money” for their long dated Bonds.

If devaluing the assets of a country by utilising “QE” to repay debt is a “programme” then it may be that even as the light of stars eventually withers into darkness the same may occur to the light within the human mind.

Posted by Greg | Report as abusive

Keep spending other peoples money US citizen. It’s about all you can do well. Can’t even make a profitable car

Posted by gd | Report as abusive

Very good article. Current government measures seem aimed in the short term at financing the banking system and in the longer term at reversing the trade imbalances generated during the past 20+ years. These policies rely on an unprecedented amount of new debt issuance.

While this crisis outcome is being financed, a major demographic imbalance is growing with the potential to dwarf the current debt issuance. The aging baby-boomer segment of the population should mature in about 10-15 years and will inevitably lead to a new, significantly greater oversupply of debt.

Inflation may be the only acceptable tax to finance this debt and its everincreasing future estimates both abroad as well as at home, respectively addressing the trade- and the demographic imbalances.

If these future policies will not lead to the balancing of the trade- and demographic imbalances, a major war will be needed to “reset” the budgets of major world economies. The world may become increasingly metastable.

Posted by Ludo Dellacqua | Report as abusive

Clearly the thing to cut is war and the War Department. Ending the wars in Iraq and Afghanistan, repatriating the troops not only from those two countries but from Germany, Korea, Japan, and the 700+ foreign bases the US presently maintains are a start.

Perhaps three or four carrier battle groups can be sold as well, to Russia, China, India or anyone else who can be convinced to buy them.

Clearly it is time to end the waste of US funds not only on the MIC, but on the “allies” who cause the wars that cost the money. Israel for instance.

Posted by John Francis Lee | Report as abusive

People are all upset that the economic system is going down the drain. But why? What’s so bad about letting go of a system that relegates human beings to being nothing more than widget producers and consumers? What’s so bad about letting the system (a system that is only concerned with how much work it can squeeze out of you during an eight hour day), simply crash?

My parents, and grandparents’ generations did some amazing things in their lives. But for all of the work they’ve done, and for all of the societal contributions their work has provided, they and many like them still ended up poor and unable to acquire many of the most basic needs or comforts.

Many of their individual contributions go unhonored. This is proven by the fact that we have so many homeless veterans, and many of them have health issues that go untended. It’s proven even today by the fact that so many working Americans who play by the rules, live within their means, and save for hard times, are suffering more than those that caused the problem to begin with.

We want the president to “fix” the system so that we can have “jobs”. But what we mean is that we want to live meaningful productive lives that make us valuable to the communities we live in. And that the value be measured not just in monetary terms, but in human terms.

If Mr Obama truly wants to change the landscape, he can start by laying out standards of conduct that all business that operate in this country must follow. Corporations must be compelled under law to be responsible contributing citizens in the communities within which they do business. And to do so without advertising it.

And that contribution must be commensurate with the needs of the community, and the wealth the business circulates/collects. Executives must be limited in the amount of compensation they receive, and any new financial system must prioritize currency as merely a medium of exchange and nothing more. The human being must be put at the center of every system we create. And the human must be of absolute highest value in any system.

The human being is currently NOT at the center of this financial, or any other system. Why else would wonderful houses sit empty while thousands of families, many with children, go homeless.

Why else would we have so many miraculous medical breakthroughs while countless masses die for lack of access to them. Our financial system doesn’t need to be fixed. It needs to be replaced with something that actually works FOR people and not against them.

Posted by Benny Acosta | Report as abusive

If only we trusted the constitution.

Posted by jason | Report as abusive

Once again, the US chooses the band-aid over a long-term solution/view. Seems this country can never see past who’s in the oval office.

Posted by Tess | Report as abusive

[…] love to see a real debate on their visions for the future.  A future that involves peak oil, a liquidity crisis turning into a long term government debt crisis, a future where our federal government seems destined to burden all of us with long term debt […]

Posted by Deficits are Devine – JordonCooper.com | Report as abusive