Paulson Plan May Push National Debt to Post-World War II Levels

By Matthew Benjamin

Sept. 23 (Bloomberg) -- Treasury Secretary Henry Paulson's $700 billion proposal to stabilize the banking system may push the national debt to the highest level since 1954, threatening an erosion of foreign appetite for U.S. bonds.

The plan, which asks Congress for funds to buy devalued securities from financial institutions, would drive the debt above 70 percent of gross domestic product and the annual budget gap to an all-time high, possibly exceeding $1 trillion next year, economists estimated.

``This is sobering, absolutely sobering, even to someone who doesn't drink,'' said Stan Collender, a former analyst for the House and Senate budget committees, now at Qorvis Communications in Washington.

At risk for the world's largest economy: a jump in interest rates prompted by the glut of additional Treasuries needed to finance the plan, and a diminished desire among international investors to add to their holdings. The dollar yesterday slid the most against the euro since the European currency's 1999 introduction.

Paulson may be questioned on the borrowing impact of his plan at a hearing at the Senate Banking Committee today that begins at 9:30 a.m. He's asking lawmakers to lift the legal ceiling on the federal debt to a record $11.3 trillion from the current $10.6 trillion.

Treasuries fell in the past two trading days after Paulson signaled Sept. 18 a sweeping rescue was needed, with the 10-year note yield rising 29 basis points to 3.84 percent. The two-year note climbed 47 basis points on Sept. 19, the most in 23 years. A basis point is 0.01 percentage point.

`Very Negative'

``The market is very, very negative because of the consequences of raising the debt ceiling and the increase in debt in general,'' Manfred Wolf, head of currency sales in New York for HVB America Inc., a unit of Germany's second-largest bank. ``Foreigners may not be that attracted anymore to U.S. assets.''

Gross U.S. debt, which includes debt held by the public and by government agencies, this year reached about $9.6 trillion, or about 68 percent of gross domestic product.

The Treasury is already borrowing to fund Federal Reserve efforts to inject liquidity into credit markets. Last week it announced sales of $200 billion in short-term debt.

``We've all used the phrase `uncharted waters' so often, yet we keep finding new uncharted waters,'' said Louis Crandall, chief economist of Wrightson ICAP, a research firm Jersey City, New Jersey. ``The fact that the Treasury's borrowing operations are now being affected on such an unprecedented scale adds new uncertainties'' to bond markets.

Bad-Debt Purchases

The Treasury's potential use of all $700 billion to purchase impaired assets would raise the country's debt to more than 70 percent of GDP. The last time American taxpayers owed as much was in 1954, when the nation was still paying down costs incurred during World War II.

``It's an alarming level of debt given that we're not fighting something like World War II,'' said Robert Bixby, executive director of the Concord Coalition, a non-partisan budget watchdog group.

The government reaching the requested debt limit would entail every man, woman and child in the U.S. owing more than $37,000 each. The median U.S. income last year was $50,233.

``We're putting a lot of debt on the books and people are going to be spending a lot of money paying that off for a long time,'' Bixby said.

Deficit Forecasts

If Treasury spends the entire amount next year, as some economists expect, it would drive next year's budget deficit, now projected to be around $500 billion, to $1 trillion or more. That would increase the annual shortfall to about 7 percent of GDP, a record level. The deficit rose to 6 percent of the economy in 1983, when then-President Ronald Reagan was ramping up Cold War-era defense spending and cutting taxes.

Michael Feroli, an economist at JPMorgan Chase & Co. in New York, says the combination of the Paulson plan, additional government expenditures, and a slower economy, could swell the deficit to $1.5 trillion -- 10 percent of GDP.

To be sure, several developed nations have debt levels far higher than that of the U.S., including Japan at 196 percent of GDP and Italy at 104 percent of GDP, according to the International Monetary Fund.

The money for the Paulson plan will go to buy assets at prices that many market analysts say are depressed. Though it's still far from clear what price the Treasury would pay for them, it's possible those assets could increase in value as the crisis recedes and, as was the case with the government's 1979 bailout of Chrysler Corp., taxpayers could ultimately profit.

``This is not an outright expenditure,'' said William Cline, senior fellow at the Peterson Institute for International Economics in Washington and a former Treasury official. ``It is essentially the U.S. becoming a market investor, and the full expectation is to make money on this stuff.''

To contact the reporters on this story: Matthew Benjamin at mbenjamin2@bloomberg.net