Chris Gaffney in The Daily Reckoning says the story that dominated the currency markets yesterday was the announcement of a record $490 billion budget deficit.

This is thanks to the slowdown in the US economy, Bush’s $168 billion stimulus package and massive spending on wars in Iraq and Afghanistan.

The question is who will purchase the debt the US Treasury needs to sell to close the budget deficit? And how will Hank Paulson entice buyers without further destroying the value of the dollar? More from Chris…

The shortfall reflects a deterioration of the budget over the past seven years. Bush inherited a budget surplus of $128 billion when he took office in 2001. The budget worsened almost immediately, because of recession, the Sept 11 attacks, the beginning of the war in Afghanistan and, later, the war in Iraq.

Believe it or not, the current projections still understate the deficit next year because the administration hasn’t requested the money to prosecute the wars for the full year, leaving that to the next president. No matter which presidential candidate gets elected, their tax and spending plans will be severely constrained by these massive deficits.

With the announcement of the record US budget deficit, it should come as no surprise that the US Treasury predicted it would borrow 53 percent more this quarter than initially forecast. Borrowing needs will rise to $171 billion in the three months to Sept. 30, $59 billion more than predicted in April. I guess the good news is that total, if realized, is still slightly smaller than the $244 billion borrowed in the first three months of this year.

The situation here is bad and seems to be getting worse. The major question remains: Who will be standing in line to purchase all of this debt? And what happens to the dollar if/when foreign investors decide they have enough IOUs from the US Treasury and need to be enticed to purchase more.

The result will be higher rates here in the US as fewer buyers will demand higher interest to encourage them to purchase the new debt.

Another way for the US to entice foreign investors is to lower the value of the US$ in order to make these new Treasury securities cheaper to purchase. I believe we will likely see a combination of the two, higher rates along with a falling US$.

Source: Budget Gap to Approach $500 Billion…