Budgets on the brink

And US President Barack Obama looks set to announce plans to combat mounting budget deficits in his State of the Union address tonight.

Now for the bad. The US will run up total budget deficits of close to $6 trillion during the next decade, according to the Congressional Budget Office.

Even this is likely to prove a wildly optimistic forecast because Obama will be sorely tempted to extend the Bush tax cuts that are due to expire at the end of the year.

And Obama's plans for dealing with the US deficit woes are already under fire. The plans to cut back spending are likely to include a three-year freeze on some elements of the budget. Already, the critics have noted that the spending items to be frozen account for less than 20 per cent of the total budget.

In recent times, the blow-out in government deficit has reflected the huge costs associated with bailing out the financial sector, and measures to stimulate the economy in the wake of the financial crisis.

But there have been other factors that have caused the total debt in the US to double over the past decade (see America is being outplayed, December 14, 2009).

US government spending has risen sharply as a result of the heavy costs of the country's military operations in Iraq and Afghanistan.

The private sector has also played its part. US consumers racked up debt to buy houses, or borrowed against their existing homes to buy new cars, plasma TVs and holidays.

Private equity firms have also played a role, using extreme degrees of leverage to finance their audacious corporate takeovers.

As a result, total US debt now stands at 370 per cent of gross domestic product (GDP). This easily eclipses the peak of 300 per cent that the US reached in the depths of the Great Depression.

The US debt burden sounds terrible, until you realize that it's much better than the United Kingdom (470 per cent) and Japan (which stands at 460 per cent).

There have been repercussions for the UK and Japan. Last year, ratings agency Standard & Poor lowered its UK rating outlook to 'negative'. It has announced that it is doing the same with Japan, because of concerns over ballooning government debt.

The other factor working in the US's favour is that, despite the massive blow-out in spending from the government sector, the private sector is absolutely determined to reduce its debt burden.

US consumers and businesses are worried, and they're cutting back their spending accordingly. As a result, business lending and consumer credit figures are contracting at record rates.

And the US has failed to rekindle its love affair with housing, despite the best efforts of the Obama team. The latest figures are far from encouraging, with home prices falling in November. This follows figures showing a plunge in existing home sales in the month of December, and a fall in new home construction.

It is possible that we'll see this pattern of expanding government deficits, and shrinking private sector borrowing, continuing for some time.

In that case, the major economies would look increasingly like Japan.

The problem is that despite successive stimulus attempts by various Japanese governments to stimulate the economy, it has done little to improve the situation. The country has managed compound growth of just over 1 per cent over the past two decades.

If the US, the UK and Europe were to head down the Japanese track, the world economy would face years of lacklustre growth. And that's scarcely an encouraging outlook for a commodity-exporting country like Australia.

But the real risk is that bond markets will take fright at the huge task it faces in financing the debt burdens of the major economies over coming years. A sharp spike in interest rates would see the cost of financing the accumulated government debt spiral out of control.

This would leave governments with little option but to slash spending in an emergency effort to preserve their finances.