The United States government spends more than it takes in, a practice that is illegal in most state governments and harshly criticized when households and businesses do it. After being the rule rather than the exception for most of the past century, why is the country’s deficit spending such a big deal now? Is the U.S. really on the edge of a precipice? Will the deficit-reduction plans under consideration in Washington work? How painful will the remedies be?

Asked to rate the issue’s importance on a one-to-10 scale, Wharton finance professor Franklin Allen says that, unequivocally, “it’s a 10. Ultimately, if we don’t get rid of the deficit we are going to have some kind of major economic crisis because of the debt…. We cannot afford to have a cessation of the basic functions of government.”

Most experts say that the U.S. is not on the brink of catastrophe — that it can muddle along for years. But they also agree that a failure to deal with the problem in the long run could undermine investments and economic growth, sparking higher unemployment, weakening U.S. competitiveness and, in general, eroding Americans’ quality of life.

Getting the deficit under control “is absolutely vital to our long-term economic health,” according to Mark Zandi, chief economist and cofounder of what is now Moody’s Failure to do so, he notes, would eventually lead to a serious rise in interest rates, choking economic growth and forcing the government to spend more and more of every tax dollar simply to make payments on past debts, leaving less for services and other government functions and dooming the economy to be “much smaller.” The choices, adds Allen, are stark: “If people want the kind of programs that we currently have, they are going to have to pay more in taxes. If they don’t want to pay, then they will have their benefits cut.”

The deficit is the annual gap between spending and revenue, and the total debt is the result of annual deficits accumulated over the decades. For the current fiscal year, the deficit is expected to exceed $1.5 trillion, up from $459 billion in 2008 and a surplus of about $128 billion in 2001. The debt now stands just shy of $14.3 trillion — the current debt limit set by Congress — compared to less than $8 trillion a decade ago. Among the most pressing issues is whether Congress should raise the debt limit so the government can continue to borrow after the current ceiling is hit in the next few months.

Higher Scrutiny

Both the deficit and debt have grown dramatically in recent years, largely as a result of the wars in Iraq and Afghanistan, government stimulus spending during the Great Recession, low tax revenue due to the weak economy and growing spending for entitlements like Medicare, Social Security and the prescription drug program enacted in 2003.

The deficit and debt were a central issue for the Tea Party movement, which helped Republicans take control of the House of Representatives last fall, forcing Republicans, and therefore Democrats, to address the issue now.

The debt crisis currently faced by a number of European countries has made the importance of the issue very apparent, even to laymen. And in mid-April, Standard & Poor’s, the rating agency, revised its outlook for U.S. government debt to “negative” from “stable,” because the country has not come up with a long-term deficit-reduction plan. Around the same time, Bill Gross, manager of the $237 billion Pimco Total Return Fund, the world’s largest mutual fund, said he had eliminated U.S. Treasuries from his portfolio due to prospects for poor returns. And China, the United States’ largest creditor, has indicated it may move to diversify into other forms of debt to reduce risk.

Governments finance deficits by borrowing, which is done by selling government bonds like U.S. Treasuries and then selling new bonds to pay off the old ones, like a consumer shifting debt from one credit card to another. “What begins to happen is that the interest rate you have to pay starts going up because people begin to worry about whether you are going to pay [the borrowed money] back or not, so they demand a higher return,” Allen says. Given the recent experience of some European countries, the danger point seems to come when government bonds begin to yield 6% or 7%, he notes. The key 10-year U.S. Treasury note currently yields 3.35%.

Accounting for debt involves some debate over what should be included, Allen adds. The current debt limit of about $14.3 trillion equals nearly 100% of the United States’ gross domestic product, with the critical level generally thought to be somewhere between 120% to 150%. But the current ceiling does not include future liabilities for unavoidable expenses like Social Security, Medicare and Medicaid. With those included, the debt may be somewhere in the $75 trillion range, or five times GDP, Allen says. “That is a level of commitment that I think we just can’t sustain without higher taxes.”

Despite all the worries, the sky has not yet fallen. Interest rates remain remarkably low — in the past, 10-year Treasuries have often yielded upwards of 5%. A number of forces shore up the demand for Treasuries, helping to keep rates low. China, for instance, cannot simply slash its Treasury portfolio because the flood of supply would weaken bond prices, reducing the value of China’s remaining holdings. And it would be hard for China to find enough other investments to take the place of the vast supply of U.S. bonds.

Kent Smetters, professor of insurance and risk management at Wharton and co-author of a paper on the subject several years ago, says investors apparently believe Washington will manage the crisis somehow, since the consequences of not doing so would be dire. U.S. Treasury securities still look safe compared to alternatives like stocks, corporate bonds or government bonds sold by other countries, he adds. “A lot of people will say, ‘Okay, you’re telling me these scary things about U.S. debt, but where else do I put my money?'”

Outside the U.S., governments with debt troubles have often adopted policies to spur inflation, allowing them to pay past debts with cheaper money. That approach is very tough on bond investors, because inflation reduces the value of their fixed earnings. Bond yields tend to rise when investors worry about higher inflation; thus, today’s low yields mean investors are not very worried that the government will choose the inflation option, according to Smetters. So the financial markets must believe the government will resort to some combination of spending cuts and tax increases, which are both easier on investors than inflation. He adds, however, that in the past many governments have indeed used inflation to reduce debt problems, so perhaps the financial markets are indulging in some wishful thinking.

The Odds of a Default

Governments cannot simply declare bankruptcy to clear their debts, as individuals and corporations can, notes Wharton finance professor Itay Goldstein. But governments do have some debt-management options aside from cutting spending, raising taxes and spurring inflation, he adds. The government could, for example, change regulations to require that pension funds hold more low-risk investments, which would force them to lend to the government by purchasing treasury bonds. Artificially inflating demand in this way would help keep a lid on interest rates, but it might dampen pension fund returns. Aside from economic growth, which boosts tax revenue, “all the other things have undesirable consequences,” Goldstein says.

In the most extreme case, the government would default, or simply stop paying bond investors what they are owed. But doing so would make it impossible to borrow, which would be essential for ongoing operations. Interest rates for all kinds of loans would skyrocket, making it hard for individuals to buy homes and cars, and for business to expand.

According to Zandi, the odds of a government default are “zero…. I think that the implications of [the government defaulting on its debt] are so serious that policy makers would not go down that path.”

Because the government constantly spends more than it takes in, it must routinely raise the debt limit, which requires an act of Congress. Sometime in the next few months, the limit will have to be raised for borrowing to continue, and the Obama administration wants to lift it while many Republicans are resisting. “There is some very small probability that they might not do it in a timely way,” Zandi says. “But even then, I don’t think the Treasury will not make the debt payments.” Rather than default, the government probably would postpone payments of other bills, such as checks for government workers and vendors. It could even, in an extreme situation, hold up Social Security and Medicare payments.

As a practical matter, Zandi notes, Washington has plenty of time to address the deficit and debt problems. “I think they will eventually find a way. I don’t think the odds are high that they will do that before the next election [in 2012]. I would say there’s probably a one in six [or] one in seven chance they would do something before the next election. I think the odds are better than even, probably two-thirds to three quarters, that they would get something done after the election.”

Currently, Washington has two major proposals, each aimed to reduce government spending in excess of $4 trillion over the next 10 or 12 years. The Republican-controlled House has approved a proposal by Rep. Paul Ryan of Wisconsin, while Democrats are generally backing President Obama’s proposal, unveiled in mid-April. While both plans leave many details unaddressed, the Ryan plan would cut tax rates in hopes that would stimulate economic growth to produce more tax revenue, dropping the top individual rate to 25% from 35%. Obama would increase tax revenue by allowing the Bush-era tax cuts for the wealthy to expire, lifting the top individual rate to 39.6%. Neither plan envisions dramatic cuts in defense spending.

Biggest Factors: Medicare and Medicaid

The biggest difference is the handling of Medicare, the health care program for people aged 65 and over, and Medicaid, the health plan for the poor. The Committee for a Responsible Federal Budget, a non-partisan group, has analyzed the plans in an apples-to-apples comparison, concluding that the president’s proposal would cut spending by $2.48 trillion over 10 years, compared to about $4.02 trillion for the Ryan plan.

The committee says Obama would continue to have Medicare and Medicaid pay for most of each beneficiary’s expenses, while seeking about $340 billion in savings over 10 years through a variety of measures such as standardizing some Medicaid pay rates, reforming the prescription drug program and attacking fraud. The goal would be to limit growth in Medicare to a rate equal to the growth of gross domestic product plus 0.5%, largely by granting broader powers to the Independent Payment Advisory Board established by the 2010 health care law. Starting in 2015, that board will have the power to set Medicare reimbursement to providers without the Congressional approval that has long been required.

Ryan’s plan would repeal the 2010 health care law and dramatically alter Medicaid and Medicare. The committee says it would attempt to save $800 billion over 10 years by converting Medicaid to a system of block grants to the states and it would try to save $600 billion by repealing the tax and coverage provisions of the health reform law. It also would limit growth in Medicare spending to the inflation rate, providing individuals with a government subsidy to help pay for health insurance policies bought from private firms through a new system of exchanges. Because health care costs tend to rise at a much higher rate than inflation, the Ryan plan would likely shift an increasingly larger share of health insurance costs from the government to individuals, but Ryan argues that competition between insurers, along with the beneficiaries’ desires to minimize premiums, would help keep costs down.

Regardless of how the government attacks the deficit problem, Medicare beneficiaries are likely to experience significant changes, according to Smetters. “The problem with the current approach is that the government pays for almost anything,” he says, noting that the practice is unsustainable.

At this point there is also no way to tell what level of medical care a privatized system would provide, or how many people could afford their share of the insurance premium, Smetters adds. Conceivably, people would have to choose from various levels of coverage, the way drivers decide on liability levels, whether to get collision coverage and how much to pay in deductibles for auto insurance.

The Ryan and Obama plans each rely on assumptions about economic growth and health care expenses that are open to debate, but both proposals recognize that Medicare and Medicaid are the biggest single factors in the deficits over coming decades, projected to produce tens of trillions of dollars in debt. Both plans implicitly acknowledge that there is not much public support for tax increases on the middle class, though they both talk about trimming tax deductions without being very specific.

Is a reform of Medicare and Medicaid an essential part of any realistic deficit-reduction plan? Can the deficit really be trimmed without tax increases? To avoid any tax increases in the long run, Medicare, Medicaid and Social Security benefits would have to be slashed, essentially to the point of undoing the reforms of Franklin D. Roosevelt’s New Deal and Lyndon B. Johnson’s Great Society, Allen says. He believes Ryan and Obama are both too optimistic about future tax revenue. Labor participation rates — the portion of the potential work force actually working or looking for work — are currently low as a result of the recession and could remain that way. Allen adds that property values may stay at depressed levels for a long time — another hit to the nation’s wealth that can dampen tax revenue. Finally, interest rates are likely to rise significantly from their current levels even if a debt crisis is averted. That will dampen growth and force the government to pay more in interest as it sells new bonds to pay off old ones, undermining the assumptions of the Ryan and Obama plans, he notes. “They are being much too optimistic about the long-term outlook.”

Any deficit-reduction plan entails a long-term process with few immediate benefits, Zandi points out. “We do need to address Medicare and Medicaid,” he says. “And, more precisely, we need to address the dramatic growth in the cost of health care. But I don’t think we need to do that now … if it’s too big a political [challenge]…. I think that’s a problem we can address a decade from now.” He adds: “The Ryan plan is too heavy handed. It’s a massive change to Medicare as we know it. It’s essentially privatizing it. But the Obama approach is too light-handed. It’s taking a tweezers approach.”

It would make more sense, Zandi says, to address the funding problems of Social Security. While politicians have traditionally been loathe to address this politically sensitive topic, Zandi notes that, compared to health care, Social Security’s problems are open to a few straightforward, well-understood remedies: raising the retirement age, trimming the cost-of-living increases in benefits, increasing the maximum income subject to payroll taxes and using means testing to determine individuals’ benefits.

Allen argues, however, that it’s not too soon to address the problems with Medicare and Medicaid, as delay will make the remedies even more unpalatable. “That’s where the big problem is 10 or 20 years from now,” he says.

On the issue of whether tax increases are inescapable, Zandi notes that experience in other countries shows they have generally fared better by closing budget gaps with spending restraints rather than big tax increases. “But I do think we need more tax revenue,” he adds, “in part because tax revenue as a share of GDP is still very low, almost close to record lows.” The best way to increase tax revenue, he argues, is to reduce deductions and credits rather than to increase tax rates. “I think that’s how they can bridge the gap politically.”

Despite the harsh political wrangling, Zandi cites some grounds for optimism. Democrats and Republicans both, for instance, emphasize spending cuts over tax increases while agreeing that some tax deductions should be trimmed. Both agree that Medicare and Medicaid need reform, and both say a deficit reduction plan should include some sort of trigger mechanism to force Congress to act if targets aren’t reached. “I have to say the different parties are much closer than I would have expected,” Zandi notes.

Allen is not so sure, arguing that eventually ordinary Americans are likely to face some unpleasant combination of tax increases or benefit cuts. “It’s good that we don’t have mandatory retirement ages anymore,” he says. “You are going to have to work longer, or cut expenditures.”