Why is Dick Cheney smiling?

Power Center: Cheney at his desk in the White House, steps from the Oval Office.

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WASHINGTON (Fortune Magazine) -- You might imagine that Dick Cheney, a well-known worrier, would be thinking dark thoughts about the economy.

Home-loan foreclosures are on the rise, banks are writing off billions, the dollar has become the butt of jokes, and bearish economists are invoking the "R" word. But that's not what has the Vice President worried.

In fact, when he looks at the subprime mortgage catastrophe that's at the root of most of the economy's troubles, he's more concerned about Washington's impulse to fix it - a view that sets him slightly apart from his Treasury Secretary and firmly at odds with well-meaning Democrats on Capitol Hill.

No, if there's anything about the economy that keeps Dick Cheney up at night, it's the prospect of sabotage aimed at disrupting the oil market, he told FORTUNE.

"Clearly the world depends on a global supply of oil, and that will continue to be true for some considerable period of time. Efforts to shut down the flow of oil could conceivably have a significant impact."

So when President Bush's 2008 budget was coming together, with the goal of balancing the budget in five years, Cheney nevertheless insisted on a $947 million line item: a speedup of the flow of crude into the Texas and Louisiana salt caverns housing the nation's Strategic Petroleum Reserve.

The budget guys pushed back: Can't we wait until crude prices level off? No, the word came back from Cheney, this was urgent. That was all it took. "He doesn't weigh in on a ton of issues," said a person close to those negotiations. "But when he does . . ."

When he does, the Vice President tends to get his way. "He's an extremely effective bureaucratic operator," says Peter Wehner, formerly Bush's director of strategic initiatives.

President Bush's economic legacy is emerging as a central debate point in the 2008 presidential campaign. But it's important to remember that this is also a Cheney legacy - one that gets less attention than his record as a chief salesman of the unpopular Iraq war and zealous advocate of executive authority, but will have trillion-dollar consequences for America's well-being.

The fact is, Cheney plays a surprisingly major role in shaping the administration's economic policy.

The Bush-Cheney economy remains a work in progress. Cheney will be wielding his unprecedented clout for one more critical year, keeping up his guard against congressional Democrats and even members of his own administration who would challenge his taxcutting, small-government principles.

In the coming months, as the administration struggles with the threat of recession, White House insiders say the staunchly free-market Vice President can be expected to resist any impulse to soften the blow with government action.

"The fact is, the markets work, and they are working," said Cheney in an interview in his White House office. "And people - some of the big companies obviously - have taken risks. Risk means risk. And there's an upside as well as a downside in some of the choices they've made. We have to be careful not to have this set of developments lead us to significantly expand the role of government in ways that may do damage long-term for the economy."

The same goes for Democratic efforts to curb the predatory lending practices that left naive homeowners in trouble, says Cheney: "We don't want to interfere with the basic, fundamental working of the markets."

Those words carry weight on Pennsylvania Avenue. Inside the White House the Vice President's role is both formal and informal. "I sit in on virtually all the economic policy sessions," Cheney says, including the regular Wednesday luncheon of economic principals. And he stands out as the one economic policy advisor with routine private access to Bush.

As the 2008 presidential race shifts into high gear, watch for the supplysider Vice President to robustly defend the twin tax cuts of 2001 and 2003, which he played a central role in crafting. Each of the major Democratic candidates wants to allow much of that tax relief to expire - especially for wealthy Americans. (A study released this year by the nonpartisan Congressional Budget Office found that the biggest tax-cut benefits went to people at the very top income levels.)

Cheney opposes any rollback. "This is identical to a big tax increase," Cheney argues. "And it will slow down the economy. We already have a tax system that is very, very progressive. The top 1% [of earners] pay 36% of all the income taxes in the country."

As he did on intelligence matters, Cheney has built his own independent network of information on the economy, drawing from a pool of more than a dozen prominent economists for private conversations.

Allen Sinai, president of Decision Economics and a self-described political independent, likens Cheney, a former Halliburton CEO, to "an executive of a large corporation who is sensitive to the risk side of things. He doesn't want to be blind-sided."

Yet is Cheney getting blind-sided on prospects for the Bush-Cheney economy? Possibly, acknowledge the more pessimistic members of his brain trust. In November 2000 on Meet the Press, the Vice President-elect publicly predicted a downturn in the Clinton economy he was about to inherit - ahead of most economists. (That prognosis also, of course, served to bolster his case that the economy needed a tax-cutting stimulus.)

Now it is Bush's economy, and Cheney says he doesn't "see signs on the horizon of a significant economic slowdown, even though we do have, obviously, higher oil prices than we've had most of the time - pretty close to the historic peak."

While energy prices in the past have precipitated slowdowns, he added, "it hasn't happened this time. I think in part that's because we're far more efficient in terms of how we use energy."

Cheney's instinct, especially when it comes to the economy, is to let the marketplace find its own solutions. That extends to the mortgage blues now haunting the Bush economy.

While Treasury Secretary Hank Paulson recently told a congressional panel he'd be "open" to a temporary, broader role for Fannie Mae and Freddie Mac to prop up the jumbo-loan market, Cheney says, "I'd be reluctant to see us go forward with a significant expansion" without first reforming those institutions.

When problems arise on any given day in the economy, says Edward Lazear, chairman of the President's Council of Economic Advisors and a Cheney confidant, even the most free-market White House official can feel an impulse to take action. Cheney stands them down. "He is very careful to remind us to do no harm," says Lazear.

There are subtle but distinct shades of difference between the President and his Vice President over economic policy. Cheney has considered himself a supply-sider for years. Bush - perhaps encouraged by studies like one by centrist economist Sinai showing federal revenue and economic gains following his tax cuts - only recently started using the label.

A Yale graduate and the son of a President, Bush is nonetheless described by some aides as more "populist" than Cheney, the Wyoming teen who got kicked out of Yale and laid power lines across remote Western plains before finally pursuing higher ambitions. Education and faith-based and other social initiatives come from Bush, not Cheney.

Take, for example, the topic of lavish CEO salaries, a political flash point because it symbolizes the rise of a historically unprecedented class of superrich in American society.

Earlier this year President Bush challenged corporate America to "step up to their responsibilities, pay attention to the executive compensation packages that you approve, show the world that American businesses are a model of transparency and good corporate governance."

Offered an opportunity to make the same case, Cheney wouldn't bite. None of his business, he said, and certainly none of the government's business: "If people have got a problem with a particular company, well, don't buy the stock."

In assessing the Cheney legacy, it's useful to think of the Vice President as the White House's resident disciple of the late Milton Friedman, the libertarian theorist Cheney turned to for advice when he worked in President Gerald Ford's White House.

Case in point: Insiders say Cheney had serious misgivings about the cost of President Bush's half-trillion-dollar Medicare drug entitlement, but the Vice President eventually went along with it on the grounds that it was a campaign promise that had to be kept. (Cheney prides himself on never upstaging the President or undermining something Bush strongly believes in.)

That's not to say Cheney's record on spending is one to boast about: Critics note that he has consistently underestimated the cost of the Iraq war - some recent estimates for the Iraq and Afghanistan wars have topped $1 trillion - and he's partnered with the biggest-spending President in 30 years, even excluding military and homeland security funding.

"Do deficits matter, Mr. Vice President?"

We are sitting at the Vice President's desk, just down the hall from the Oval Office. Underneath a picture directory of the 110th Congress and surrounded by photos of Cheney's six grandchildren sits Hunter Lewis's new book, "Are the Rich Necessary?," a compendium of essays arguing both sides of the most provocative economic questions of the day.

For Cheney the deficit question is an especially pertinent one, since during heated internal debates over proposed tax cuts in 2002, he reportedly told a skeptical Paul O'Neill, who was then Treasury Secretary, that "Reagan proved deficits don't matter."

So do they? "They do," Cheney answers with his trademark terseness. "The [deficit] conversation, as I recall, was in a political context. But deficits, if you're going to look at deficits - and you should - you've got to evaluate them relative to other priorities. Another priority, for example, would be defending the nation in wartime. And you need to look at deficits relative to the total size of the economy, which oftentimes we don't do."

The deficit question haunted the Republican Party in the 2006 congressional election and will surely do so again in 2008. (While the federal deficit has shrunk from a record $413 billion in fiscal 2004 to $163 billion in 2007, a slowdown in the economy will send it right back up again.)

Long the party most trusted to control government spending, the GOP was forced to defend a President who signed pork-laden legislation. Fiscal conservatives reacted with disgust, while gleeful Democrats piled it on, bringing up the good old days of Clinton-era surpluses.

At the moment, with government tax receipts on the rise, Cheney is on more solid ground - at least on deficits. Still, the spending question haunts the Republicans politically.

Keenly aware of that, Bush is wielding his veto against Democratic spending bills, declaring that the congressional majority is "acting like a teenager with a new credit card."

Democratic leaders have responded with a credit card reference of their own, pronouncing his spending lectures "priceless."

The Bush administration, meanwhile, has challenged Congress to carry out an almost impossible task: to eliminate the alternative minimum tax, politically unpopular for its increasing bite on the middle class, without raising any new taxes to make up for it. That would mean cutting roughly $800 billion in spending over a decade.

Alan Greenspan, a 30-year friend who used to spend Sunday afternoons at the Cheneys' kitchen table in McLean, Va., before the vice presidential residence became their home, complained in his recent memoir about "the President's unwillingness to wield his veto against out-of-control spending."

Some of that responsibility falls into Cheney's domain. As part of the President's Budget Review Committee, the Vice President has the power to nix appeals from cabinet secretaries seeking more funding in the budgets the President sent to Capitol Hill. Cheney also has the power to counsel the President to veto the pork-laden bills that came back.

The issue has come up in discussion, his aides say. "I would bring to his attention the fact that spending rates were growing at alarming rates, even exceeding the Clinton rates," recalls Cesar Conda, his former domestic-policy advisor. "I remember bringing him the charts. I think he shared my concerns. I'm assuming he went to the President, but there's only so much you can do."

And what of Greenspan's critique of spending under Bush? "Well, he was especially critical with respect to entitlements," Cheney says. "I think our administration worked harder on that than any administration ever has. And I thought his criticism of the government generally - and he focused especially on the Congress - it's hard to argue with."

Cheney calls Social Security and Medicare "the deficit I'm really worried about." Yet as Cheney concedes, he and the President "couldn't move that ball very far down the field."

Cheney reached his status as the nation's supply-sider-in-chief after a career experiencing just about every fashion trend in economic policy.

One of his first federal-government jobs was working under Donald Rumsfeld to enact President Nixon's wage and price controls, a disastrous attempt to curb inflation as the 1972 election approached.

"I always felt it was one of Nixon's most serious mistakes," recalls Cheney, whose job was to oversee 3,000 IRS agents snooping through businesses. "It seriously distorted the economy."

Chapter two in Cheney's evolution came inside the Ford White House, where the chief of staff drew on advice from such staunch free-market thinkers as Friedman and Greenspan.

One afternoon at the Two Continents bar a couple of blocks from the White House, economist Arthur Laffer pulled out a pen and drew a curve on a white linen napkin to demonstrate to Cheney how cutting taxes could inspire people to work harder, produce more, and pay more in taxes. "My reaction at the time was, well, that's interesting, but I didn't run out and say, 'Mr. President, Mr. President, you've got to cut taxes,' " Cheney recalls.

He borrowed supply-side rhetoric in his 1978 run for Congress, but for most of his congressional career representing Wyoming, he was a balance-the-budget advocate.

In early 2001, however, the Vice President threw his weight against the concerns of Greenspan and Treasury Secretary O'Neill, who wanted tax cuts conditional on deficit levels. Bush signed a tax act that would cut $1.35 trillion over ten years.

Then came 9/11, when an already weak economy was badly battered. In early October, Cheney invited in a group of economists - Lawrence Kudlow, John Makin, Wayne Angell, and Allen Sinai - for advice.

"The consensus was that the economy needed a large tax cut," recalls Conda. Cheney worked publicly and privately to ensure it would be a hefty one. In one speech he rejected arguments that big deficits led to higher interest rates, prompting Greenspan to send over a report challenging his claim, according to Cheney biographer Stephen Hayes.

Another opponent was O'Neill, who later told author Ron Suskind that he believed the economy was doing fine and that an expensive stimulus package would "tie our hands on major tax reform or on creating Social Security private accounts." O'Neill had picked the wrong foe. A few weeks after a confrontation over the tax cut in late 2002, O'Neill was out of a job. If Cheney thinks he's right, says Conda, "he'll use all the levers to get it done."

Treasury Secretary Paulson was recruited by chief of staff Josh Bolten in 2006 and still enjoys a power base independent of Cheney.

In an important symbolic shift, the Wednesday luncheon of economic principals that Cheney attends was moved from the White House to Paulson's territory, inside the Treasury building. Still, Cheney continues to weigh in - relying heavily on the advice of Lazear, the President's economic policy director Al Hubbard, and his outside brain trust.

A trademark concern of Cheney's is the surprise high-impact event that leads to chaos. Preserving a sufficient national oil supply in the event of a terrorist attack fits right into that portfolio.

"He's a big supporter of the Strategic Petroleum Reserve," and would like to see an even faster flow of oil into the system, says Lazear.

The discussions between Cheney and other officials center less on what an attack might look like than on what a disruption to world markets would do, he adds. "He believes it pays to buy insurance," Lazear says. "And oil is 'liquid' - in both senses of the word. Holding some of the U.S.'s wealth in the form of oil," Lazear notes, is also a financial safety net.

Critics on Capitol Hill and in the energy industry have accused the administration of exacerbating high oil prices with its current plan of squirreling away crude - let alone pursuing Cheney's more ambitious desires for the Reserve.

National security concerns will continue to shape Cheney's economic influence in the coming year. As Halliburton CEO, he publicly opposed sanctions that would prevent U.S. companies from doing business in Iran. Now, of course, he is focused on squeezing Tehran economically in hopes of halting its nuclear program, "even though that may be painful and frustrating for somebody in the private sector who has to live with it," he said.

On monetary policy Cheney maintained a tight relationship with Greenspan until the Fed chairman's 2006 retirement, and then supported the appointment of chief White House economist Ben Bernanke to the post.

Some in Cheney's brain trust believe that Greenspan's money policies were too loose - and contributed to the housing bubble that burst. "The Fed was extremely easy from 2002 to 2005. It was not desirable or necessary, and it set off this huge real estate boom," says economist Angell, a Fed governor from 1986 to 1994.

This is a view that Angell and other outside economists have shared with Cheney, but the Vice President insists he respects the Fed's independence.

"I, as a general proposition, think Alan Greenspan was a good Fed chairman."

Just a few nights before his interview with FORTUNE, Cheney had dinner with Greenspan at the home of friend, mentor, and deposed Defense Secretary Rumsfeld. As the guests assembled, Cheney offered effusive compliments to Greenspan on his recent memoir.

Cheney's copy holds an inscription, but the Vice President won't reveal the contents. "He's still got a few secrets left," he says of his economist friend. And so does Dick Cheney.