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While governments often engage in deficit spending during recessionary periods to create demand and soften the blow of a downturn, the U.S. federal government is now entering its third year of recovery with higher deficits. The estimated federal budget deficit for 2011 ($1.5 trillion) is up from $1.3 trillion in 2010 and $1.4 trillion in 2009. Many worry that these deficits are becoming unsustainable. See the following article from Money Morning for more on this.

On the heels of U.S. President Barack Obama's State of the Union address - during which the commander in chief highlighted the need for investment in innovation - a steep federal budget deficit projection yesterday (Wednesday) showed the harsh reality of the U.S. government's spending spree.

In the Congressional Budget Office's (CBO) economic outlook report, the nonpartisan body estimated the budget deficit would reach $1.5 trillion in 2011, or 9.8% of gross domestic product (GDP). The report cited the Bush-tax-cut extension, low production, and a weak labor market as key factors for reducing revenue, increasing spending and pushing the deficit higher in fiscal 2011.

This year's federal budget deficit is up from $1.3 trillion in 2010 and $1.4 trillion in 2009. The deficits, when measured as a percentage of GDP were the largest since 1945, reaching 8.9% in 2010 and 10% in 2009.

The CBO said that GDP would grow 3.1% in 2011, but revenue growth will continue to move at a sluggish pace due to continued policies like tax cuts and unemployment benefits extensions. While 2011 government spending for financial crisis issues like the Troubled Asset Relief Program (TARP) is winding down, other outlays like Social Security, Medicare, and Medicaid will continue to grow.

It's common for the government to engage in deficit spending after an economic downturn to breathe life into an ailing economy. But Money Morning Contributing Editor Martin Hutchinson said a deficit over $1 trillion this far into recovery mode is a red flag.

"The fact that the 2011 deficit has moved from $1 trillion to $1.5 trillion in the third year of recovery is very worrying," Hutchinson said. "As output recovers, revenues normally increase and expenses decline and the budget moves toward balance. Thus each year of $1 trillion-plus deficits is more worrying than the last."

Hutchinson said the effect on concerned markets of a growing government spending imbalance is similar to the European debt crisis.

"At some point the bond markets will panic, and we will become Greece - but there's no EU to bail us out," Hutchinson said.

Hutchinson highlighted the problems with President Obama's State of the Union message in yesterday's Money Morning issue with his article, "State of the Union: Why You Should Fear America's ‘Sputnik Moment'." He said the president's goal to freeze domestic spending is flawed because it's based on "grotesquely bloated budgets of 2010-2011," offering only "windy rhetorical support" to the deficit commission, instead of useful suggestions.

"Obama last night had specific ideas of how to spend more money, but nothing specific on how to cut back," Hutchinson said.

While President Obama asked Congress to rein in federal spending, he also proposed more investment in education, infrastructure and renewable energy. Republicans have criticized President Obama's expansive use of the word "investment" - especially in cases where it's clearly a euphemism for "increased spending."

House Republicans, who gained control in November's midterm elections, will be a roadblock in the president's investment plans, as they aim to significantly cut government spending in 2011.

"Whether sold as ‘stimulus' or repackaged as ‘investment,' [the Democratic leadership's] actions show they want a federal government that controls too much; taxes too much; and spends too much in order to do too much," Rep. Paul Ryan, R-WI, said in the Republican response to the State of the Union address.

But even with cuts, the country is bound to see some spending initiatives gain approval, with their price tags tacked on top of borrowing that is nearing the debt limit of $14.3 trillion. Hutchinson said Americans can expect to see talk of a value-added tax as the government hunts for a way to cover its debt.

"[I]t's the one real revenue spinner, at roughly $50 billion per percentage point per annum. A push for it will certainly be made immediately in 2013 if Obama is re-elected, and maybe before," said Hutchinson.

President Obama will submit his budget request for fiscal 2012 in the second week of February, which will provide a more detailed outline of fund allocation for the coming year.

Further CBO estimates for the years after 2011 showed a decline in the federal budget deficit and its percent of GDP. The CBO projected a $1.1 trillion deficit in 2012, $704 billion in 2013 and $533 billion in 2014, representing 7%, 4.3% and 3.1% of GDP, respectively.

But the CBO noted that its projections understate the federal budget deficit should the government extend many current policies beyond their expiration dates. It estimated that if many of the recently extended tax cuts remained in force, and Medicare payment rates were held constant, debt held by the public would reach 97% of GDP by 2021- the highest level since 1946.

The CBO said to prevent debt from reaching record levels, the government would need "to substantially restrain the growth of spending, raise revenues significantly above their historical share of GDP, or pursue some combination of the two approaches."

Of course, a more a more balanced budget that could drastically reduce public debt and the federal deficit is hardly in the immediate future, says Hutchinson.

"We should probably expect the deficit to remain about $1 trillion until something really serious is done about it," Hutchinson said. "And I don't see that happening with the current combination of forces."

The CBO also projected that inflation would remain low through 2012, and average no more than 2% a year through 2016. The unemployment rate, currently at 9.4%, is expected to fall only to 9.2% in 2011 and 8.2% in 2012, but will hit 5.3% in 2016, near the CBO's 5.2% "natural rate" of unemployment.

"Inflation is definitely going up, and will be much higher than 2% in 2012, rising sharply thereafter until there's a new Fed," the CBO said. "Unemployment may get back to 5.3% with good policies, but there's a problem in the long-term unemployed, who may become unemployable - far more of them than in previous cycles."

Hutchinson said the country faces a high chance of another economic crisis that will erase any short-term improvement in the unemployment rate.

"The financial sector has not deleveraged post-crash and is now extended again." Hutchinson said. "I expect another crisis well before 2016."

This article was republished with permission from Money Morning.