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Why Complacency About the Deficit Could Be Lethal

NEW YORK (TheStreet) -- The Congressional Budget Office has forecast the federal deficit at $506 billion during the current fiscal ending September. The deficit has gone down. That sounds positive in the short term and hugely negative in the long term.

First the good news: though a slight rise from the April forecast of a deficit of $492 billion, due to a fall in income from corporate taxes, the deficit is still less than the $680 billion deficit in the prior report. This would also be the fifth consecutive year the deficit has fallen as a share of GDP from 9.8% in 2009 to 2.9%.

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The murkier picture beneath the seemingly balanced short-term prediction is this: the CBO expects the accumulated federal debt held by the public to reach 74% of GDP by the end of this year -- the highest debt-to-GDP ratio since 1950 -- and 77.2% by 2024.

Why should the federal government stop being complacent and start worrying about something 10 years from now?

There are ample reasons. First, debt reaching 77.2% of GDP is not too far from the 90% that is seen by many economists as the danger mark Crossing that would push the economy toward collapse. Inflation would shoot up, interest rates would spiral and private investment would slump. This would severely hurt all Americans, especially the middle class, the elderly and the have-nots.

Spiraling federal debt would also escalate the chances of a sudden fiscal crisis, dampening investors' confidence in the government's ability to manage its finances. The government would begin to lose its ability to borrow at affordable rates to meet expenses, becoming trapped in a vicious cycle.

Debt at stratospheric levels would pull down growth steeply and severely hamper the federal government's capability to respond to out-of the-blue challenges, possibly precipitating a debt-driven financial mess.

The U.S. has already hit the debt ceiling and raised it with great difficulty. Three years ago, after an acrimonious debate, President Barack Obama and Congress decided to lift debt ceiling to $16.39 trillion from $14.29 trillion, in exchange for a series of spending cuts spread over 10 years. McGraw Hill (MHFI) -owned Standard & Poor's responded by cutting the country's glossy AAA credit rating.

Now the government does not have too many options at hand. It is staring at the double whammy of already-bloated debt and expenditures and an even greater climb in future debt and costs. To rub salt to the wound, spending in Social Security and Medicare is expected to mount further. Besides, surging interest on existing and expected debt will gulp down possible returns from tax collection.

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The U.S. could learn a lesson or two from the travails of the European countries whose debt crossed 90% of GDP in 2011.  Greece touched a debt-to-GDP ratio of 165%, Italy 100% and Portugal 97%. The combination of bailout and fiscal austerity cobbled together by European lawmakers couldn't restore investors' lost confidence in Greece's ability to manage its debt.

Is drawing a parallel with European economic weaklings such as Greece realistic? Well, predictions of the 2008 financial crisis were denounced as unrealistic when they were made years before the deep slump.

So what should the federal government do?

Mounting obligations to entitlement programs and spiraling expenditures are two battles that should be fought first. The president and Congress should initiate harsh but realistic steps to balance the federal budget over the long term.

At the time of publication, the author held no positions in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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