Economists worry that Iraq, deficit will be drag on growth

WASHINGTON -- President Bush's request for $87 billion in new spending for Iraq and Afghanistan will worsen already gloomy forecasts for the budget deficit -- sending it above the half-trillion-dollar mark next year -- and could ultimately translate into weaker economic growth in the United States.

That is the assessment of private economists who believe the surging federal deficits, while helping to boost a lagging economic recovery this year and next, will mean trouble down the road in the form of rising interest rates and higher inflation.

This scenario of a classic "guns and butter" conflict between competing military and domestic priorities was visibly demonstrated in the 1960s when President Lyndon Johnson's "Great Society" programs ran up against escalating costs for the Vietnam War, triggering higher inflation and rising interest rates.

Bush administration officials, briefing reporters on the details of the president's plan, rejected this scenario. They said the additional $87 billion that Bush is seeking for military operations and reconstruction will not prevent the administration from achieving its goal of cutting the budget deficit in half over the next five years.

But these officials, who spoke on condition of anonymity, conceded the request will add from $50 billion to $60 billion to next year's deficit, which the administration projected in July would hit a record $475 billion.

Given that administration officials said they would not seek any offsetting spending reductions in other areas, that would mean a deficit next year of $525 billion to $535 billion, using the administration's projections.

$480 billion deficit

The Congressional Budget Office, in its own midyear update last week, put the 2004 deficit at $480 billion, a figure which did include estimates on additional spending on the Iraq occupation in 2004. Private analysts said they believed the deficit figure will easily exceed $500 billion next year based on their belief that Bush's $87 billion request will prove insufficient to meet the needs in Iraq.

The CBO is forecasting that the deficits over the next decade will total $1.39 trillion, a remarkable turnaround from when President Bush took office and officials were forecasting surpluses over a decade that would total $5.6 trillion.

Part of the deterioration in the government's books reflects the 2001 recession and the weak recovery since that time. Analysts said the administration was right to push through tax cuts and increased government spending to jump-start growth over the past three years.

Many now believe growth will be boosted by more than 1 full percentage point this year and next because of the stimulus provided by Bush's third round of tax cuts, which took effect this summer, and the increased government spending on the military and homeland security.

"The tax cuts are getting spent and all the money the government is spending to buy new tanks and planes and missiles represents jobs as well," said David Wyss, chief economist at Standard & Poor's Co. in New York.

The trouble will come, analysts said, if the huge deficits persist, as they now expect, after the economy starts growing at faster rates.

Then the government's huge borrowing costs will bump up against investment needs of private companies seeking to expand and modernize. The increased demand represented by higher government and consumer spending will threaten higher inflation in an economy operating at full capacity.

Higher interest rates and higher inflation will mean slower economic growth.

"We are on an irresponsible path for fiscal policy," said Martin Baily, senior economist at the Institute for International Economics and head of the Clinton Administration's Council of Economic Advisers.

Baily said this deficit binge was occurring at a time when the country needs to be preparing for the coming retirement wave of baby boomers, which will put severe strains on government benefit programs.

He said the $1.4 trillion 10-year deficit estimate by CBO does not include the cost of making Bush's tax cuts permanent, estimated at $1.1 trillion through 2013, and something the president has said will be a top priority.

Other private economists also questioned how long the U.S. commitment in Iraq will last. The $87 billion request will cover just the 2004 budget year, which begins Oct. 1.

While the biggest concern is what the huge deficits will do in terms of crowding out private borrowing needs once the economy picks up steam, many economists said they believe the spectre of huge deficits in the future was already having an impact on long-term interest rates, which have been rising steadily since mid-June.

"Investors' expectations are being changed," said Mark Zandi, chief economist at Economy.com. "I don't think anyone anticipated the magnitude of the commitment we are now taking on in Iraq."