War Swells the Tide of Red Ink

By Ryan Brecht The prospect of military action against Iraq had been one of the main wild cards for the U.S. budget outlook. And now that the shooting has started -- and Bush Administration announced on Mar. 25 that it's seeking $74.7 billion to pay for the conflict and the war on terrorism -- the risks to Uncle Sam's pocketbook have come into sharper focus.

Pressure on the budget has been increasing all year, as the sluggish economy has put a sizable hit on tax receipts. Meanwhile, spending has soared on increased outlays for military, homeland security, and entitlement programs. Given that this may be the first in a string of funding requests related to the war, it seems likely that the Treasury will report a significantly larger deficit this September than had been widely expected even a few months ago.

Indeed, assuming that the President's $75 billion funding request is passed, we at MMS International think the U.S. now probably faces at least $400 billion in red ink for the fiscal year, compared to the record $325 billion previously forecast.

FLEXIBLE FUNDING. The bulk of Bush's war supplement request is earmarked for costs related directly to the deployment of troops and equipment in Iraq. Indeed, $63 billion would be allocated to military and intelligence operations, with almost the entire amount directed to the general defense emergency response fund. It assumes the Pentagon's estimates for the costs of the first 30 days of fighting, beginning last week. Designating this portion of the budget in this way gives Defense Secretary Donald Rumsfeld considerable flexibility in allocating these funds. The remaining $12 billion is split between the State Dept. and foreign aid.

While the conflict's duration and magnitude remains uncertain, it seems safe to assume that the $75 billion will be only a first installment. Even assuming the best-case scenario of a speedy end to the fighting, the U.S. must still reckon with the expense of rebuilding Iraq. While these costs cannot really be projected yet, as the extent of the damage is still uncertain -- and unfinished -- the Council on Foreign Relations Task Force estimates a price tag of $20 billion per year to cover occupation, rebuilding, and humanitarian assistance.

In addition to the budget impact, the costs of war and homeland security have hampered the President's ability to push his tax-cut plan through Congress. Indeed, on Mar. 25 the Senate voted to slash the proposal to $350 billion from Bush's original request of $726 billion ($100 billion of that was reserved for funding the war) worth of stimulus measures.

ZOOMING RATES? The original, full request was previously passed by the House along party lines. With legislators on both sides of the aisle increasingly expressing concern over the tax cut's impact on the deficit given war costs, it's unlikely that anything but a heavily modified tax package will land on Bush's desk.

Besides the political implications of the larger deficit, the amount of new government debt issued to pay for the war effort will have a major impact on the Treasury market. Safe-haven demand for Treasuries has been the key factor in keeping interest rates at or near the lowest levels in four decades. But once the war is completed -- and the safety premium is taken away -- interest rates will zoom higher.

A surge in supply of new Treasury issues will exacerbate the sharp rise in bond yields. It's worth noting that the Treasury has already reintroduced a quarterly three-year note auction, beginning with the upcoming May refunding, and will institute regular reopenings of five-year note auctions in March, June, September, and December. These two factors will add eight new offerings to the Treasury issuance cycle.

And more may be coming. Treasury officials are considering reopening 10-year notes or going to monthly sales of five-year year notes, and they expect to expand the issuance program for inflation-indexed issues (TIPS) in the coming quarters. So as Bush, Rumsfeld & Co. ratchet up the war effort, the Treasury will have to muster some financial firepower of its own. Brecht is a senior economist for MMS International