(MONEY Magazine) – The economy is surging, unemployment is shrinking, and the Dow has reconquered 10,000. So why then is Robert Rubin convinced the sky is falling?

Blame it on a federal budget deficit that's spiraling past $500 billion. The normally circumspect former Treasury Secretary is accusing Congress and the Bush administration of creating "truly horrendous fiscal conditions" that, left unchecked, will lead to higher interest rates, fewer jobs and a lower standard of living. "We face the high probability of a very serious day of reckoning," Rubin told a friendly (Democratic-leaning) crowd at New York City's 92nd Street Y in November.

Three thousand miles away in Newport Beach, Calif., another financial luminary--this one a Republican--is voicing similar concerns. Bill Gross is the chief investment officer of Pimco Funds and the manager of the nation's largest bond fund. If you thought Rubin's outlook was dark, Gross' is downright apocalyptic. Gross believes we face a future of "higher import costs...rising inflation...perhaps chaotic financial markets" and "bond market sell-offs destroying the housing market." The nation, he contends, is overextended. "We're trying to do too much, borrow too much, spend too much," Gross wrote in a September commentary. "We are a country in the beginning stages of what can be aptly described as hegemonic decay." Needless to say, Gross thinks this is a lousy time to buy U.S. stocks and bonds.

What's going on? How can the economic outlooks of two of the nation's most respected money men diverge so drastically from the facts on the street? After all, the economy grew at a raucous 8.2% clip in the third quarter of 2003. The unemployment rate has dipped below 6% for the first time since last March. Interest rates have remained low. And there's not a whiff of inflation--the core inflation rate now stands at 1.1%, the lowest level in 38 years. It's almost as if Rubin and Gross are looking at an entirely different economy.

They aren't. What they're doing is firing the first volleys in the inevitable national debate on government spending and the future of our economy. As the 2004 campaign unfolds, America's financial health will be a central issue if the Democrats have any hope of unseating Bush. To be sure, neither Rubin nor Gross frames his arguments in partisan terms. (Rubin takes particular pains to distance himself from electioneering.) But they do call attention to the reality that deep tax cuts and massive spending initiatives like the Medicare drug benefit cannot coexist indefinitely. Sooner or later, we must decide how big a government we want and how much we're willing to pay for it. Just how soon is what the deficit debate is all about.

The concerns raised by Rubin and Gross boil down to a question that has been roiling the economics community for years: How much do deficits matter? Rubin and Gross say they matter a lot--particularly when coupled with a widening trade gap and the crisis looming for Social Security and Medicare once baby boomers start to retire. The risks are so evident, says Berkeley economics professor and deficit hawk Brad DeLong, that the only dissenting economists are "those who have been bought and paid for by [Bush political adviser] Karl Rove and company." Hyperbole aside, the "deficits matter" crowd does seem to be a majority: Three out of four U.S. investors believe that the federal budget deficit is hurting the investment climate, according to a recent Gallup poll.

"The fourth is an economist," quips Kevin Hassett, a conservative economist with the American Enterprise Institute who has a much different view. While he's no fan of big government or the increased government spending under Bush, Hassett rejects any link between deficits and interest rates. He believes today's deficits will serve a useful purpose by putting the brakes on government spending.

Not all deficit skeptics are conservatives--Jared Bernstein of the liberal Economic Policy Institute has his own doubts about a link between rates and deficits. Nevertheless, enough skeptics are right of center that what might have been an academic debate has become a hot political issue.

RUBINOMICS 101

For Rubin, the issue is also personal, since those who downplay the impact of deficits are casting doubt upon his own legacy in government. The lore of Rubinomics goes something like this: Back in January 1993, Rubin convinced then President-elect Clinton that appeasing the bond market was the first step toward jump-starting the economy. Bond yields were high, he said, because bond investors were worried about the deficit. As Rubin writes in his new memoir, In an Uncertain World, "Bondholders were demanding a higher return, based both on the longer-term fiscal outlook and on the risk that the politics of re-establishing fiscal discipline would be too difficult and that, instead, our political system would attempt to shrink the real value of the debt through inflation." Once the bond market realized that the administration was serious about running a surplus, he told Clinton, interest rates--then nearly 7% for 10-year Treasuries--would fall. That in turn would spur consumers to spend and businesses to invest.

Gross liked what he was hearing. "He's paying attention to the bond market for a good reason," he said of Clinton in 1993. "It's all he's got to give him a chance to make [his programs] work." And for many Americans, the next seven years bore out the wisdom of Rubin's plan. By the end of Clinton's second term, the interest rate on the 10-year Treasury had fallen to 5.6%, unemployment was down to 4%, the stock market had more than tripled in value, and the Gross Domestic Product (GDP) was growing at a 5.9% clip (almost double the historic norm).

Once the economy stumbled in 2001, Rubin concedes that getting money into the hands of people who would spend it became a high priority. But in his view, more modest temporary tax cuts targeted at low- and middle-income people would have provided the necessary stimulus more effectively and efficiently. Instead, he argues, the Bush tax cuts have set off a dangerous long-term escalation of the national debt. As the Treasury issues more bonds to cover the debt, it will have to pay higher rates to make them attractive to buyers.

GROSS & THE CHINA SYNDROME

For deficit hawks, the adverse effects go well beyond the cost of paying off today's debt. Gross maintains that the reason the dollar is now falling is because foreign creditors prefer bonds of countries with "budgetary disciplines resembling that of an adult as opposed to a neurotic teenager with a credit card." He contends that the only reason there hasn't been an economic crisis is that China and the other Asian countries with which we're running huge trade deficits are using our dollars to buy Treasuries.

Gross thinks it's only a matter of time before China realizes that propping up the dollar to keep its exports attractive to U.S. consumers isn't worth the risk of holding half a trillion or so in U.S. notes and bonds. "China holds the keys to our kingdom and our Hummers," he says. "Their willingness to buy our bonds, their philosophy of fixing their currency to the U.S. dollar, will one day be tested. And should their patience be found wanting, all of their neighboring Asian China wannabes will move in near unison." The upshot for the U.S.: higher interest rates, slower economic growth, more expensive consumer goods in our malls and showrooms and, ultimately, a lower standard of living.

CROWDING OUT

Even if Gross' China syndrome doesn't play out--the falling dollar may say more about higher Eurobond yields and improved economies in Europe than it does about fiscal problems here at home--deficit hawks still think that higher rates are inevitable. They subscribe to a theory known as "crowding out." As Joshua Feinman, chief economist for Deutsche Asset Management, explains it, "The more claims the government makes on the pool of savings, the less money that's going to be available to the private sector." Crowding out is essentially supply and demand: The more demand for a fixed supply of lendable money, the higher the price (that is, the interest rate).

Problem is, evidence that crowding out actually occurs is hard to come by. (See the chart on page 57.) The reason rates don't seem to react to deficits, says AEI's Hassett, is that even $500 billion in newly issued Treasuries represents less than 1% of the $60 trillion global debt market. "I was sitting next to Rubin [during a closed hearing] at the House Ways and Means Committee when he said that the first Bush tax cut was so fiscally reckless that it would lead to serious distress and much higher interest rates," says Hassett, a former economist with the Federal Reserve. "Well, here we are 2 1/2 years later and economic growth is higher and interest rates are lower. It doesn't mean there's no cost to deficits, just that you shouldn't panic."

Hassett sees no connection between deficit reduction under Clinton and Rubin and the economic successes of the '90s. "In the 1990s, we had this incredibly wonderful technological boom that was associated with the diffusion of the computer into all areas of production and the productivity gains that accompanied that diffusion," he says. Business cycles, he adds, are "caused by exogenous events--not by government policy."

Rubin responds that today's low interest rates are misleading because they reflect corporate America's current reluctance to borrow money or sell bonds. For the time being, "there's no collision between private and public demand for capital," he says, but that won't continue. Rubin questions whether he used the words "fiscally reckless" when talking to Congress but affirms that he did--and does--consider the Bush tax cuts unsound.

THE WHITE HOUSE VIEW

Caught in the middle of this intellectual tug-of-war is the chairman of President Bush's Council of Economic Advisers, N. Gregory Mankiw, a former Harvard University economics professor considered a leading expert on deficits and their impact. Yet figuring out exactly where Mankiw stands on deficits is not easy. In some of his 1990s writings, he echoed the Rubinomic assumption that deficits weaken the economy and raise interest rates; in one textbook Mankiw even asserted a formulaic relationship between the size of deficits and reductions in GDP. Yet in a 1995 paper, "The Deficit Gamble," Mankiw and his co-authors argued that while deficits are "imprudent," they "do not lead inexorably to future hardship" and are more likely to stimulate the economy than damage it.

Back then, Mankiw put the odds of deficits doing actual harm at a mere 10% to 20%, reflecting the possibility that an external shock--say, an oil crisis--could force the government to raise taxes immediately. According to Mankiw, that risk may be unacceptably high for a buttoned-down economist, but not, perhaps, for a politician.

Mankiw's deficit-gamble argument is essentially this: Since the average interest rate on government debt is lower than the average growth rate of the economy, the government can run big deficits--even $500 billion ones--for a number of years. "It can forever roll over the debt and accumulated interest," he wrote, "because the economy's income will likely grow faster than the debt will accumulate." So politicians aren't necessarily full of it when they talk of growing their way out of a deficit.

Today, Mankiw insists that President Bush is concerned about the deficit and will make specific proposals for cutting it once the administration's 2005 budget proposal is released in February. The budget deficit is now approximately 4.5% of GDP. Bush "wants to cut that in half within five years," Mankiw says, through a combination of spending restraint and economic growth.

To him, Rubin's criticism sounds more political than economic: "The issue is not only the economic question regarding the effects of budget deficits but a political judgment over whether Robert Rubin and others believe us when we say we're going to cut the budget deficit in half. Mr. Rubin may have a different judgment."

"I guess I do," replies Rubin. He points out that nondefense discretionary spending has increased at an annual rate of 8% under Bush, with Republicans in control of both houses of Congress for most of that period. "So I would suggest that, at least thus far, there doesn't seem to be an enormous focus on restraining spending."

WHO'S BEING REALISTIC?

One reason Rubin is so skeptical about the administration's promises is the sheer size of the problem. Most recent estimates from the Congressional Budget Office (CBO) project a deficit of $480 billion in 2004 and a cumulative 10-year deficit of $1.4 trillion between 2004 and 2013. However, a report jointly issued by three fiscal watchdogs, the Committee for Economic Development, the Concord Coalition and the Center on Budget and Policy Priorities, contends that the cumulative deficit over those 10 years will actually be three times bigger. (See "Playing the Numbers Game," above.)

What troubles Concord Coalition co-founder Warren Rudman most is what happens after 2013, when the first wave of baby boomers will have reached retirement age. The coalition estimates that spending on Social Security, Medicare and Medicaid entitlements will rise from 8.5% of GDP today to 14.9% in 2030 and 18.4% in 2050. The result: an explosion of the federal debt from about 40% of GDP today to 100% by the late 2020s and 400% by the late 2040s. "The demographics are such that at the end of the tunnel is an oncoming train, and there's no way to step aside," says Rudman, a former Republican U.S. senator from New Hampshire. "People today who are under 40 are going to pay a terrible price--their marginal tax rates are going to be very high and the value of their currency is likely to be much lower."

As for the arguments that we can grow our way out of current and future deficits, Rudman says they're nonsense: "If we could grow the economy 6% or 7% every quarter for the next 10 years, maybe we could do it. But I don't see that happening--particularly with so much of our basic industries now going overseas."

This is frightening stuff, yet it's worth remembering that the most hopeless political problems can be solved. Even Ronald Reagan raised taxes when deficits grew too large. Taxes could be raised again. The retirement age could be increased. Social Security and Medicare could be subjected to means testing. These are tough choices politically, but the longer we put them off, the more debt we'll incur.

Is all this debt likely to ruin our economy? We certainly won't know in November, when we cast our votes on the administration's stewardship of the economy. Mankiw gives a deficit gamble an 80% to 90% chance of success. And he may be right. With Bob Rubin and Bill Gross on the other side of the wager, is that a bet we should take?