(FORTUNE Magazine) – When Alan Greenspan testified before congress in mid-February, the Fed chairman delivered a Valentine's Day garland to the recent performance of the U.S. economy, lauding the "stunning increases in productivity" that have fueled the recovery. But that same testimony included a far darker message: Greenspan reminded Americans that the U.S. economy faces a giant threat in the guise of big budget deficits stretching far into the future. In the past, Greenspan had mainly warned of the looming dangers of deficits in a decade or so, when the baby-boomers start retiring en masse. This time he hinted strongly that raging deficits could derail today's recovery. "Deficits could cause difficulties even in the relatively near term," intoned the chairman in his usual courtly style. In Greenspan-speak, that means the wolf is at the door, and he could start biting in months, not years.

It is astonishing how quickly we've gone from big budget surpluses to massive budget deficits. Between 1998 and 2001, the U.S. generated some $560 billion in surpluses--including a $236 billion surplus in 2000--and it was widely assumed that the era of big deficits was over. Indeed, in 2000 the Clinton administration was giddily predicting that the country would pay off all of the debt held by the public--some $3.4 trillion--by 2010.

But a year later the budget fell into deficit, and it's been spiraling downward ever since. Last year the deficit was $375 billion, and this year it is projected to be a staggering $521 billion. (The government's fiscal year ends in September.) Not surprisingly, the deficit is quickly becoming a hot election-year issue. Which is to say, there's not a lot of straight talk on the subject. Democrats invoke the need to balance the budget, but they never mention the source of half our fiscal mess, that government spending is now largely out of control. The Bush administration, meanwhile, has projected that the deficit will shrink in half by 2009. But to get to that number, the administration had to make a series of assumptions that are nothing short of laughable, as we shall see. Add to those bogus assumptions the administration's steely determination to not raise taxes, and, well, we've got a big problem.

What's truly scary--what makes this deficit problem different from past deficits--is the trend: huge budget deficits from here to eternity. There is simply no way, with current government spending patterns, that the budget will ever be back in balance--not without tax hikes that would be unacceptably high and ruinous to the economy.

What is also scary, though, is the seeming indifference of this administration to the looming deficit problem. In a widely quoted passage from the new book The Price of Loyalty, Bush's former Treasury Secretary, Paul O'Neill--the one real deficit hawk in the administration--quotes Vice President Dick Cheney as telling him, "Reagan proved that deficits don't matter." If that is really what the Bush administration believes--and to be fair, Cheney denies it--then we're in a lot more trouble than we realize.

Deficits matter for three reasons. First, they increase the national debt, which in turn drives government spending even higher by tacking on ever-increasing interest expenses each year. Second, they put our economy at the mercy of foreign governments and investors, whom we have to count on to buy that debt. And third, they represent an unwillingness to come to terms with government spending. The more the government spends as a percentage of GDP--and right now the federal government absorbs 20% of GDP--the greater the drain on resources available for Americans to spend and invest in the private sector. As legendary economist Milton Friedman told Fortune, "What really matters is spending. Whether you finance the increased spending by borrowing or by raising taxes, you're leaving less resources for the private sector."

That is not to say the deficits are always bad. Think of the government like a household: If it borrows to meet an emergency, and if the borrowing is temporary--and creditors know it's temporary--the dollars generated by the debt can prove a boon by sparking economic growth. To put it another way, deficits aren't a problem if they're cyclical--if the creditors believe that as soon as the economy rebounds, the U.S. can bring its revenues back in line with spending.

Right now America is leaning heavily on foreign investors and governments, especially Japan and China, to buy the government debt that funds the deficits. At the moment, those investors are giving us the benefit of the doubt: They're still convinced that we'll get a grip on our deficits. That's the reason they're still buying our 30-year Treasuries for a rock-bottom 5% yield. But if the rest of the world loses confidence in our fiscal management--and that is now a legitimate fear--interest rates will spike. As Greenspan says, America must take action toward "restoring fiscal sanity."

We have, of course, been down this road before. In the late 1970s, deficit spending and, most of all, too much monetary stimulus by the Fed helped push up interest rates to the point where, by the early 1980s, they were wreaking enormous havoc on the economy. Then-Fed chairman Paul Volcker succeeded in squeezing inflation out of the economy, though in the process we had to endure a terrible recession and double-digit unemployment in parts of the country. But deficit spending soared under Ronald Reagan's presidency--and interest rates remained relatively high. Still, even during the Reagan era, the deficit began coming down--in part because Reagan signed a series of tax hikes into law.

In retrospect, the presidencies of George H.W. Bush and Bill Clinton represent something of a golden age of fiscal management. In 1991, displaying the kind of admirable political will that it could use now, Congress passed the hugely important Budget Enforcement Act, which clamped tight caps on discretionary spending, which includes all the money that Congress has to authorize each year--as opposed to mandatory spending, which includes big-ticket entitlement programs like Social Security and Medicare. The law also forced Congress to pay for the new entitlement spending with cuts in other entitlements, notably Medicare. That same year Bush signed into law his own tax hike--a move that helped doom his presidency, because it went back on his infamous "Read my lips" pledge, but which also helped bring the deficit under control.

The effect of the Budget Enforcement Act was quite stunning: From 1995 to 1998, outlays for nondefense discretionary spending grew by an astoundingly modest 1% a year. By 2000, government outlays had dropped to 18% of GDP, from 22% in 1992. By any measure, that was a heroic accomplishment, though strong growth helped a lot.

The combination of spending restraint and tax hikes helped revenues take off. But there was also some luck involved. First, the peace dividend at the end of the Cold War enabled the U.S. to vastly shrink spending on defense. Between 1990 and 1999, military outlays dropped from $300 billion to $275 billion. Second, in the late 1990s, entitlements still weren't growing as fast as GDP--thanks to a moderation in health-care costs and the slow rate of increase in Social Security beneficiaries. Amazingly, between 1996 and 2000, spending on Social Security, Medicare, and Medicaid actually fell, from 8.2% of GDP to 7.6%. And finally there was the effect of the bull market and the Internet bubble. In 2000 and 2001, for instance, receipts from capital gains jumped to more than $100 billion a year after averaging less than $50 billion in the mid-1990s.

Today, of course, the situation is virtually the opposite. Most of the uncontrollable factors that helped create a surplus in the late 1990s pushed us toward a deficit by 2002. Take capital gains. With the market in the doldrums, revenues from capital gains have shrunk from $119 billion in 2000 to $45 billion just three years later. In the wake of 9/11, Bush has understandably ramped up defense spending far above what Clinton planned. Bush's forecasts for future defense spending don't look big until you consider that he's leaving out future appropriations for Iraq, which are estimated at $50 billion next year alone. Homeland security accounts for billions more. Rising health-care charges have driven up the cost of Medicare and Medicaid. By 2010, shifting demographics will cause a steep rise in Social Security payouts. Today those three huge entitlements are up to 8% of GDP and are due to grow to 10% by 2014--and an intolerable 14% by 2030.

But at every step along the way, this administration has exacerbated the deficit problem with its shocking lack of fiscal restraint. One example was the steep tax cuts President Bush first proposed in 2001. The original rationale was that taxpayers should get a portion of the surplus rebated to them. Then the economy started faltering, and the surplus began shrinking. In the face of these changing circumstances, Treasury Secretary O'Neill argued that the tax cuts should be abandoned or at least pared back. But the administration pushed them through anyway, arguing that the weak economy needed the stimulus. By 2003, receipts as a percentage of GDP slumped to 16.5%, a postwar low; this year they're expected to fall even lower.

What's more, although the administration gives lip service to the Republican credo of smaller government, its actions suggest otherwise. Just look at the numbers: From 2001 to 2004, in a mere three years, spending outside defense and homeland security and defense-oriented foreign aid has jumped 23%, or more than 7% annually. In the same period, federal aid to education, for example, rose almost 50%, to $57 billion. Discretionary spending on health care, a category that includes the budgets of the NIH and CDC, rose 44% in those three years. The result? Federal spending is back up to 20% of GDP, and the Brookings Institution estimates that it is on track to reach 22% of GDP by 2014. "Within only a few years," concluded a recent report by the International Monetary Fund, "the hard-won gains of the previous decade have been lost." That same report concluded that about half of the big swing from surplus to deficit was due to the stock market crash and the economy's slowdown. The other 50% was a product of the Bush tax cuts and the big ramp-up in federal spending.

Perhaps the best single example of lack of spending discipline was the Medicare prescription-drug benefit Congress passed--and the President eagerly signed--in late 2003. By the administration's own (undoubtedly conservative) calculations, the new Medicare drug benefit will cost $60 billion a year by 2009. Without it, Medicare spending was expected to rise around 6% annually. With the drug benefit, Medicare spending is likely to jump over 10% a year. It's a budget breaker if ever there was one.

So what is the Bush Administration proposing to get the deficit back under control? So far, not much--which is precisely what has to make our creditors nervous. White House budget projections over the next five years call for the deficit to shrink in half--but many of the assumptions upon which that number is based are simply not realistic. For instance, it assumes that the economy will grow at an average rate of 3.5% from 2004 to 2009, which is pretty optimistic. ("Achieving 3.5% would be a record worth crowing over," says Robert Reischauer, former chief of the Congressional Budget Office.) It also assumes that nondefense discretionary spending, excluding Homeland Security, will drop in actual dollars, from $454 billion to $430 billion, from 2005 to 2009. This isn't just optimistic, it's implausible; over the past 40 years, discretionary spending has never dropped for a sustained period. What dropped was the rate of increase.

It gets worse. The Bush budget offers $65 billion in refunds to help uninsured Americans purchase health-care coverage--but doesn't include a concomitant $65 billion rise in spending. Why? Because it promises to find $65 billion in offsetting spending cuts. How? It doesn't say.

Or take the alternative minimum tax, a complicated levy that imposes a surcharge on high-earning taxpayers with lots of itemized deductions. In 2001 and 2003, Congress lifted the amount of income excepted from AMT from $45,000 to $58,000 until 2004. But though the administration swears it is dedicated to reforming and reducing the AMT, its budget assumes just the opposite: that the AMT exemption will revert to $45,000 from 2006 to 2009--which would result in 30 million Americans paying the tax by 2009. It's hard to imagine that the administration would allow that to happen--and yet without it, tax revenues will fall by 3% from current White House forecasts.

The Brookings Institution ran numbers using more realistic forecasts for spending increases (higher) and tax receipts (lower) than in the President's highly optimistic budget. Though Brookings is a liberal think tank, its spending numbers are fairly conservative; if anything, they could get far worse. Brookings reckons that even if Congress imposes relatively spartan restraint on discretionary spending, the deficit will still stand at $500 billion in 2009, precisely where it is today.

It's not just the brookings institution either. Most top Republicans don't believe the White House numbers. "It will be extremely difficult to reduce the deficit below today's dollar levels at all over the next five years," says Bill Hoagland, budget advisor to Senate Majority Leader Bill Frist.

And that's the real problem. It's not so much the current size of the deficit--which at 4.5% of GDP is actually smaller than the Reagan deficits of the mid-1980s--it's the trend. Put simply, using reasonable assumptions, spending is slated to remain far higher than revenues into the blue horizon. That's what has to be reversed--and quickly. Otherwise, America's fiscal credibility is at risk.

So what should we do? For starters, we need to bring back the Budget Enforcement Act, which expired in 2002. What was so important about the BEA is that it forced Congress and the White House to make tough choices: If politicians wanted to up spending in one area, they had to find offsetting cuts in another area.

To its credit, the Bush administration has suggested reviving the BEA. Under its plan, the law would cap increases in all discretionary spending at less than 1% a year, while requiring that all new spending legislation be offset by cuts of equal size in other entitlements. Bush's plan doesn't go far enough, though. It should also include another set of sharp teeth in the original BEA: Any new tax cuts should also trigger equal cuts in spending or tax hikes somewhere else.

Ultimately, the goal should be to keep federal spending right where it is now, at about 20% of GDP, while balancing the budget over, say, a ten-year span. To do so will require more than just controlling spending, important though that is. It will also mean imposing some tax increases--or rolling back recent tax cuts.

Most painful of all, it will require regaining control over entitlements, especially Social Security and Medicare. "They're America's exploding cigar," says Bill Gale, a senior fellow at Brookings. According to the OMB, if entitlements are left alone, federal spending as a share of GDP will grow from 20% to 28% by 2035. Though they remain America's biggest sacred cows, entitlement programs will break us if we remain unwilling to wrestle them to the ground.

Two possible ideas: Social Security benefits are currently indexed to the consumer price index, despite strong evidence that the CPI overstates cost-of-living increases. Greenspan recommends moving to a more accurate index, which would lower the annual benefit increases. Another good idea: Raise the eligibility age to 68, reflecting the greater longevity of Americans nearing retirement.

If the deficits keep running, America's total debt will hit $9.7 trillion by 2014. That's 54% of GDP, the highest number in 50 years and a major red flag for the foreign investors buying our debt. By then we'd be drowning in $500 billion a year in interest payments, three times the current amount.

That's the bad news. The good news is that Americans are starting to pay attention to the growing deficit. It's beginning to feel a little like 1992, when Ross Perot ran for President using his famous charts that illustrated the nation's growing sea of red ink. "I've seen the budget issue swing from big attention to lack of attention," says Hoagland, Senator Frist's budget expert. "I'm a deficit hawk. Now I'm back in vogue." Not a moment too soon.

REPORTER ASSOCIATE Christopher Tkaczyk

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