Taxpayers have to shoulder trillion-dollar deficit

By Alan Beattie in Washington bailout

On top of a string of unprecedented events stemming from the credit crunch, the US Treasury's $700bn rescue plan for distressed mortgage assets seems likely to give us another: the first trillion-dollar deficit in history.

The long-term cost, or even profit, of the operations being launched in Washington depends on a number of known unknowns and, possibly, some unknown unknowns. But whatever the final cost to US taxpayers, they are directly or indirectly providing a backstop for assets totalling a great deal more than the federal government's $5,400bn (£2,950bn, €3,750bn) in debt.

The US was expected to run a federal deficit of $438bn, or 3 per cent of gross domestic product, next year, the Congressional Budget Office said. The $700bn mortgage securities rescue fund is authorised for two years, but even if not all is spent in the first year, the federal deficit could easily top $1,000bn next year, economists say.

Ken Rogoff, a Harvard academic and former chief economist at the International Monetary Fund, says: "I can't imagine this crisis is going to end up costing the government less than six to seven per cent of GDP." In practice, it could cost more. Democrats in Congress have talked about providing direct help to homeowners in addition to the asset-purchasing plan - a move likely to come next year rather than as part of this emergency package.

The costs are uncertain because the performance of the economy over the next year or two is likely to determine not just whether that deficit swells further - tax revenues fall during economic downturns - but whether taxpayers will be asked for fresh support. George Magnus, senior economic adviser to UBS, says: "Much depends on what happens with house prices and further deleveraging." If the vicious circle of falling asset prices, reduced debt and asset sales continues, he says, more government action will be needed. "Paulson is talking as though this is just a mortgage problem, whereas it goes beyond that," he says. "The financial sector needs recapitalising and I think the state will have to do it."

As well as the upfront cost, the US government is also implicitly underwriting a vast amount more risk. In assuming responsibility for Fannie Mae and Freddie Mac, the troubled mortgage institutions, it has taken on their gross liabilities of some $5,400bn, equivalent to the current federal debt.

If it is going to stand behind the money market mutual funds industry, as suggested by its extension of federal insurance to the institutions at the end of last week, that means back-stopping a further $3,400bn worth of assets. In addition, through its various operations including the rescues for AIG and Bear Stearns and emergency direct lending to banks, half of the the Fed's assets are now riskier instruments rather than safer US Treasuries.

Of course, it is almost inconceivable that anything near these risks would crystallise into actual losses. But it adds to the uncertainties of the final costs to taxpayers. "The government is now putting its arms around enormous chunks of the US financial sector," Mr Magnus says.

Whether the taxpayer ends up making a profit or loss from all these operations is the great unknown, since it is impossible to know the true value of the assets it will be acquiring.

But there is no doubt that being an American taxpayer just got a lot more expensive in the short term and a lot riskier further down the line.

Additional reporting by Krishna Guha