The Federal Reserve building in Washington, D.C. The Fed can buy Treasurys, relieving the market of supply pressures, as it did during and after the 2007-09 financial crisis.
Photo: Andrew Harrer/Bloomberg NewsThe coronavirus pandemic is about to test the bounds of how much debt the U.S. government can bear.
Even before the crisis hit, the U.S. was on track to increase its budget deficit to nearly $1 trillion in the fiscal year that ends Sept. 30. It was already up to $625 billion in the five months since the current fiscal year began Oct. 1.
Now analysts say the deficit will soar well past the record $1.5 trillion hit in 2009, when the U.S. reeled through two years of financial crisis and recession.
Moody’s Analytics estimates the budget gap will hit $2.1 trillion this year and $1.8 trillion the next. J.P. Morgan economists project deficits of $1.7 trillion this year and $1.5 trillion next. Decision Economics Inc. projects $1.9 trillion this year and $2.5 trillion next.
The economic outlook is so fluid that many analysts can’t keep up with their budget estimates.
“We’ve done two major revisions to our outlook in the last three weeks, and we are in the middle of doing a third,” said Lewis Alexander, a Nomura Securities economist who worked in the Treasury Department during the Obama administration.
The budget deficit is how much government revenue—from taxes and other sources—falls short of spending on everything from the military to Social Security to unemployment benefits. The government borrows to cover these shortfalls by issuing Treasury bonds.
The deficit is set to surge for three reasons: First, reduced household incomes and corporate profits mean lower federal tax revenues. Second, spending is going to climb on safety-net programs such as unemployment insurance or food stamps that will be tapped more heavily as unemployment rises. Third, Congress and the Trump administration are negotiating economic-rescue packages that could add $1 trillion or more to the bill. State governments face similar squeezes.
Total federal debt—the accumulation of past annual deficits—is now $23.5 trillion, which includes debt held by the public and debt held by government agencies such as Social Security trust funds. At the rate the debt is about to grow, it could surpass levels reached after World War II, as a percentage of gross domestic product.
“We have to deal with debt and deficits at some point down the road,” White House economic adviser Lawrence Kudlow said Wednesday on Fox. “But during crises or wars, you have got to sort of not worry about borrowing.”
What is unusual about this moment is that the debt was already so high before the current crisis, when the nation wasn’t in a major armed conflict or in recession. Normally during peacetime expansions, deficits decline and the growth of debt moderates or it even contracts. In the late 1990s, for example, the U.S. government produced budget surpluses and started paying down debt.
This time, the deficit, at 4.7% of GDP in 2019, was already well above levels seen during the 2001 recession and near levels seen during the 1990-1991 recession. That was due to tax cuts and a surge in government spending on military and other programs.
Economists have been debating for several years whether large debts and deficits matter anymore. Interest rates are exceptionally low, in part because of very low inflation. That means the government can finance its borrowing at very little cost. Short-term interest rates are near zero and the yield on a 10-year Treasury note is near 1%.
Many economists long warned that high levels of debt relative to GDP couldn’t be sustained without slowing growth or fueling high interest rates or inflation. But others have said recently that may not be true, or that debt levels would have to be much higher than currently to have such harmful effects.
“Given the zero rates, I believe that very high levels of debt are sustainable,” said Olivier Blanchard, former chief economist at the International Monetary Fund.
In times of crisis, investors tend to seek out safe-haven assets like Treasury securities. Government debt also tends to be appealing to investors during times of very low inflation like now. Both factors suggest that interest rates will stay low and that the government will be able to keep funding large deficits without negative repercussions.
However, there is a risk. Bond investors could revolt against the sheer scale of bond issuance from the Treasury that is about to hit the market and demand higher yields on those bonds in return. That would mean higher interest costs for the government, and also for many other kinds of borrowing that is often benchmarked to Treasury securities, such as mortgages, car loans or business loans. Economists call it “crowding out” when government borrowing hurts the private sector.
During the 1980s and 1990s, some economists came to believe the mere threat of higher deficits could push up interest rates and counteract the boost to growth that larger deficits sometimes produce through greater government spending or tax cuts.
“These fiscal package numbers are kind of scary” in terms of the supply of government bonds that will be hitting the market in the near term, said Thomas Simons, senior vice president and money-market economist in the Fixed Income Group at Jefferies LLC. Long-term bond yields have risen in recent days. Yields on 10-year Treasury notes have risen to more than 1.2% Wednesday from 0.6% on March 9
However several analysts said the rise is associated with other factors, not deficit fears, and will likely subside. Among them, hedge funds and other investors have been unwinding losing trades called “basis trades,” which tend to perform well during periods of little market volatility. With the market now highly volatile, the trades are being removed, which involves selling some Treasury bonds and pushes yields higher. Another factor is selling by investors who simply need to raise cash quickly.
Roberto Perli, an economist at research firm Cornerstone Macro, said that if investors were responding to the prospect of a fiscal breakdown specific to the U.S., yields on Treasurys would widen relative to other sovereign debt, such as German bunds. Instead, U.S. rates have been following similar patterns as other sovereign rates.
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The fallback is the Federal Reserve. The Fed can buy Treasury securities itself, relieving the market of supply pressures, as it did during and after the 2007-09 financial crisis in programs that came to be known as quantitative easing.
It has massive capacity to do so. Between December 2007 and December 2016, it expanded its holdings of Treasury securities by $1.7 trillion. It gradually started winding down those holdings but has reversed that process. On Sunday, the Fed said it would buy another $500 billion of Treasury securities and $200 billion of mortgage-backed securities.
The central bank’s only real constraint on these purchases is inflation. During the Fed’s quantitative-easing programs, many critics, particularly on the right, said the programs would cause a surge in inflation by pumping so much money into the financial system and financing large government deficits. Instead, inflation remained persistently below the Fed’s 2% target, as it is now. In theory, the Fed can keep buying government debt as long as inflation remains controlled.
“Policy makers cannot afford to be overly concerned about deficits right now,” said Harvard University professor Jason Furman, a former Obama administration economic adviser. “The developments over the last two days are not an argument for fiscal policy to do less, they are an argument for monetary policy to do more to expand QE.”
A collapsing economy without government support, he warned, would do more fiscal damage than many of the programs that are designed to prevent it.
—Sam Goldfarb and Nick Timiraos contributed to this article.
Write to Jon Hilsenrath at jon.hilsenrath@wsj.com
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