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Costly war in Iraq could force tough choices for U.S

WASHINGTON—The need for more U.S. troops in Iraq is a potent reminder that if the cost of the American mission there continues rising, the United States may be forced to choose between raising taxes and letting the federal budget deficit grow even bigger.

Either one could slow economic growth.

The Bush administration and Congress have made a series of costly, open-ended spending commitments, from remaking Iraq and Afghanistan to creating a prescription-drug benefit under Medicare. At the same time, the president's tax cuts have shrunk revenue.

As a result, Wall Street analysts think the federal budget deficit will remain around $500 billion a year for the foreseeable future, despite promises by President Bush and his Democratic challenger, Massachusetts Sen. John Kerry, to halve it in five years.

The recent increase in violence in Iraq, coupled with the withdrawal of some private contractors and foreign troops, underlines how hard it is to predict how long the United States will be there and how much the American-led occupation will cost.

The Pentagon told Congress this week that it would need another $4 billion to get through the fiscal year that ends Sept. 30. That's on top of $87 billion approved in a supplemental budget for Iraq and Afghanistan for this year.

The White House is expected to ask for $50 billion to $75 billion for Iraq and Afghanistan in the 2005 fiscal year.

"It's a major new expense that has to be accounted for in the budget," said Robert Bixby, the executive director of the Concord Coalition, a budget watchdog group in Washington.

In tough economic times, budget deficits boost the economy, as they have since the 2001 recession. The deficit is adding as much as 1.6 percentage points to economic growth, according to estimates by the International Monetary Fund, the Washington institution that lends money to countries in financial crisis.

But in a strong economy, deficit spending becomes harmful. By 2007, the U.S. budget deficit will be trimming more than a percentage point off growth, the IMF study projects.

Mainly, that's through higher interest rates. The government must borrow to finance the deficit, and that pushes up interest rates for all borrowers. Higher rates depress home buying and other major purchases such as cars. Higher borrowing costs for businesses slow investment in new buildings and equipment.

Over time, lower business investment can impose another economic cost. Business investment in new technology and equipment is a major driver of productivity, or increases in economic output per hour of work. Productivity increases are what lead to a higher standard of living, either through higher wages or lower prices.

Ideally, the government would rein in spending. But commitments from Iraq and Afghanistan to Medicare and homeland security make that virtually impossible.

"We have too many requirements for homeland security and defense" to bring down the budget deficit significantly, said Lyle Gramley, a consultant to Schwab Soundview Capital Markets. "To keep interest rates from rising too much, we may have to make some tough decisions as a nation."

Some economists draw parallels to the "guns and butter" policies of the Vietnam era, when the Johnson administration triggered years of federal budget deficits with an escalating war and new programs to fight poverty but no tax increases to pay for them. The deficits of the late 1960s and 1970s, together with the 1973 oil crisis and a low interest-rate policy at the Federal Reserve, fueled a combination of rampant inflation and economic stagnation—"stagflation."

The guns and butter metaphor implies that government can't afford both at the same time. Spending more on guns ultimately requires spending less on other things.

"At the present time, the guns are Iraq, Afghanistan and the war on terrorism, and the butter is the tax cuts," said Ed McKelvey, a senior economist at Goldman Sachs investment bank in New York.

To battle stagflation, the Fed eventually was forced to raise interest rates dramatically, which curbed inflation but caused unemployment.

Severe inflation is unlikely today, as the Federal Reserve has learned the lessons of that earlier era. The Fed would raise interest rates quickly if necessary to prevent inflation from getting out of control, and with inflation unusually low today, that's not an immediate problem.

But as the economy strengthens, the issue could come to a head by the end of next year or in 2006, said Gramley, a former Fed governor.


(c) 2004, Knight Ridder/Tribune Information Services.

GRAPHIC (from KRT Graphics, 202-383-6064): 20040423 USIRAQ COSTS


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