(MONEY Magazine) – The U.S. economy continues to face uncertainties unparalleled in recent memory, from the conflict with Iraq to the threat of terror to weak business spending and earnings to overcapacity from the telecom and technology bubbles. Although a resolution in Iraq will likely relieve most of the pressure on the economy and markets, some experts are questioning whether the recovery will falter--and whether we can afford further tax cuts, given the costs of war with Iraq.

To gain counsel on these issues, I recently spoke with one of the country's most respected economists, Martin Feldstein, the former chairman of the Council of Economic Advisers under President Ronald Reagan. Feldstein is a professor at Harvard and president of the National Bureau of Economic Research, the group responsible for tracking recessions. His analysis of our political economy is always compelling.

GUNS AND BUTTER?

DOBBS: There is a considerable debate as to whether the United States can afford both the President's proposed economic plan and tax cuts, while at the same time prosecuting a war on terrorism and a conflict with Iraq. Can we?

FELDSTEIN: My position is that we can afford both. Given the weakness of the economy, providing tax stimulus will be a good thing for the country. So that's the short term. And the President's plan delivers a certain amount of money in 2003 and significantly more in 2004. I think, from a stimulus point of view, it's something that we want rather than being a problem. And for the longer term, the President's plan gives us good tax reform.

Q. What about the impact on the budget deficit?

A. You've known me for a long time, and I am a deficit hawk from way back. But the size of the deficits that we're looking at over the next 10 years are much smaller relative to gross domestic product than they were in the past. In the mid-'80s, we had deficits equaling 4.5% of GDP and a debt-to-GDP ratio that was rising sharply. Currently, even when you add back into the Congressional Budget Office's projected numbers all of the things critics talk about--the growth of spending, the need to reform the alternative minimum tax--you still end up with deficits that are around 1.5% of GDP and a debt-to-GDP ratio that doesn't rise from its current roughly 35% level. So I think the answer is that we can afford it over the next 10 years, and it's a plus in the short run.

Whenever I read the newspapers, they say, "Do you know this [tax cut] is going to cost $700 billion over 10 years?" And I think, but does the guy who just wrote that sentence know that the [total] projected nominal GDP over those same 10 years is $144 trillion?

Q. The Democrats put forward their own plan with considerably more emphasis on short-term stimulus. What do you think of the Democratic plan?

A. It doesn't have any of the favorable incentive effects. It doesn't do anything to deal with the double taxation of corporate profits, which is a big focus of the President's plan. My belief is that, in the end, there will have to be a negotiation. Although you don't get any good long-run effects with the Democrats' plan, you do get some short-run stimulus out of it.... My preference would be to have some of the Democratic proposal if that's the cost of getting the President's proposal, rather than having a stalemate in which we get neither.

HOLES IN THE ECONOMY

Q. Going back to your earlier point--that there is weakness in the economy requiring stimulus--how weak or how strong is this economy? What is your outlook for the remainder of this year?

A. I think the economy is weak. And we don't really know how much it will come back because of the psychological lift that will come from the end to a war in Iraq. I assume we will start to find that out fairly soon.

On the other hand, I do worry that some of the other conditions are not going to be changed by getting Iraq behind us. That when the fog of war lifts, we will still have households with substantially reduced net worth and a very low savings rate that they might want to lift in order to rebuild net worth. And that we have businesses that are operating with 75% capacity utilization rates that are going to take a wait-and-see attitude about doing more capacity-expanding investment. I worry that even when Iraq is behind us, we're not going to see a return to the kind of numbers--3.5% growth--that a fraternity of forecasters is now pointing to.

Q. You're suggesting that after the situation with Iraq is resolved, the business investment slowdown could continue and there could be a slowdown from the consumer side as well?

A. I think what you said is exactly right--"could." It could be that psychology will change and consumers will feel that they can go out and spend. If they do, then that spending, plus the rising income that comes from good productivity, can lead to a higher spending rate that starts to draw down inventories and perhaps pushes up demand to invest. And we live happily ever after. But I think there are these serious risks.

Q. What is the risk here of recession?

A. The National Bureau of Economic Research still hasn't declared an end to the previous recession. The primary reason we haven't is that employment hasn't gotten back to the levels that would make you say if the economy dipped further that we were clearly in a new recession. Payroll employment now, as you probably know, is lower than it's been since sometime in the year 2000.

Q. What's the solution?

A. If [employment] doesn't pick up, I think we will see, rightly, a bit more monetary stimulus. Most of the time, I would be nervous about fiscal stimulus because the track record is pretty poor. In the past, it's come too late, stimulating the boom rather than shortening the recession. But at this point, given where we are, it's a risk worth taking. I would advocate a fiscal relief package. I would make the President's plan the centerpiece of it, but I wouldn't object to adding more.

Q. What do you see as the principal risks to the equity and bond markets?

A. I think the principal risk is the rest of the world's willingness to continue to finance these enormous trade account deficits at existing low interest rates. We've got 5% to 5.5% of GDP being financed by capital inflow from the rest of the world--most of it into the bond market. So we are very dependent upon foreign willingness to [invest] under existing interest rates.

Q. What goes through your mind when you hear discussions about reprisals in the economy against the French and the Germans for their political positions?

A. I don't think that's going to happen. I think people are annoyed, rightly. But we're not going to stop having Volkswagens here or French wine.

Q. Do you believe we've gone far enough with corporate reform with the Sarbanes-Oxley corporate reform legislation?

A. In some ways, we've probably gone too far. We've put in place this very convoluted set of requirements on boards--some of which make sense, but some of which may not make sense. I think on balance it was a good change, but I think there will be a shake-out over time. They've already pulled back or revised some of their rules. Will it be a foolproof system? Absolutely not.

THE NEED FOR TAX RELIEF

Professor Feldstein's thinking has influenced mine for years, so it should be no surprise that I agree with him that we continue to face significant risks, even after Saddam Hussein has been deposed and a resolution has been reached in Iraq. Geopolitically, we will still face the threat of radical Islamist terrorists. And economically, we will still have to grapple with weak employment, disappointing corporate earnings and continued overhang from the technology and telecom bubbles. Congress would do well to follow President Bush's lead and push for further tax relief.

Lou Dobbs is the anchor and managing editor of CNN's Lou Dobbs Moneyline.