It was revealed Thursday that the George W. Bush administration intends to present a budget showing deficits of $400 billion for each of the fiscal years to October 2008 and October 2009, at a time we are close to an economic peak. Given a normal recession, that means the next “trough” deficit will probably be over $1 trillion. The final report card can now be written on the fiscal management of the Bush administration, the primarily Republican Congresses since 2001 and the Federal Reserve Chairmen of the period. One’s only regret in writing it is that no grade lower than F has been discovered.

Budgetary management in a democracy is damn difficult, to be fair. The voting public gets only the most vague and generalized benefit from spending cuts, while the affected lobbies and interest groups are energized to their maximum squawking intensity by the idea that their precious budget handouts or tax reliefs might be removed. On the other side, tax cuts are inevitably skewed towards the wealthier taxpayers, since they pay most of the tax in the first place, but no amount of electoral juggling can lead the wealthy to form an electoral majority.

If taxation and government spending had no economic effect, as people believed between the 1950s and the 1980s, and elections determined the share of output retained by the state, the equilibrium political state would be something like Sweden, in which the state takes around 60% of Gross Domestic Product and doles it out in an egalitarian manner in health, education, pensions, disability payments and other benefits. The private sector would be limited to food and consumer goods in which there was no plausible rationale for state management (even alcohol is a state monopoly in Sweden, for example, and is inordinately expensive).

However in practice increasing the size of government damages economic output, in three ways. First, resources are diverted from the economically optimized (by the price mechanism) private sector) to an area where decisions are made on a political basis, so are generally nowhere near economically optimal. Second, increasing marginal tax rates is subject to a severe law of diminishing marginal returns on the supply side. At low rates a small increase will produce only modestly less than would be expected by a linear analysis, but a high marginal rate, above 40% or so, or a sharp increase has repeatedly been shown to be counterproductive in terms of revenue raised, often producing a reduction in revenue where an increase had been expected. Third, institutions that are subject not to the disciplines of the market but to the imperfect controls of a large government bureaucracy become corrupt, and that corruption, which is proportionate to the resources controlled, represents pure loss of output to the economy as a whole.

Thus even in honest pious Scandinavia the big government nirvana has been proved sub-optimal, and in a country with a US or Mediterranean level of graft it would quickly descend into chaos. The problem is then that the adverse economic effect of a large public sector is inchoate and diffuse, whereas the forces tending to enlarge it are ever-present and powerful. The Founding Fathers, almost all of them wealthy men, were very aware of this problem and attempted to limit the expansion of the federal government, partly by making the income tax unconstitutional. 19th Century economists helped by establishing a consensus that budget deficits were bad, thus limiting the ability of government to grow without inflicting immediate pain upon the taxpayers.

However in the early 20th Century, the progressives, economically more or less illiterate but appalled by the sight of nouveau riche businessmen consuming conspicuously, removed these barriers. First they passed the Sixteenth Amendment, allowing an income tax. Then they discovered the joys of Keynesian economics, which de-linked revenues and expenditures, allowing budget deficits and spending to be justified as economic “stimulus” whenever the economy was performing at less than 105% of capacity. Control of the Federal Reserve System enabled them to remove the short-run monetary constraints that had previously prevented over-expansion, and the road to larger government was cleared. The Great Depression and intermittent wars fueled the increase; expansions of government that would have been impossible in peacetime were justified as emergency measures, and then embedded in the system, so as to persist after the emergency ended.

By the late 1970s the economic costs of ever-increasing government had become obvious both in Britain and the United States, and the political consensus in favor of it was defeated by two determined leaders, Margaret Thatcher and Ronald Reagan. That defeat was only temporary however, as demonstrated by the failure of their successors John Major and the Bush family and the rise to prominence of supposed “Third Way” leaders in Tony Blair, Bill Clinton and, as it turned out, George W. Bush.

Blair and Clinton discovered simultaneously that much of the cost of increasing government could be disguised for many years, if it was done gradually and combined with an excessively loose monetary policy. They were assisted providentially by the Internet communications revolution, which allowed an increasing proportion of the world’s consumer goods to be produced in low wage economies at declining costs – this prevented the surge in consumer price inflation which would otherwise have been inevitable.

Bush came to office promising a reduction in the size of government and in particular a tax cut, both traditional Republican policies strengthened by Reagan’s success in the 1980s. Instead Bush, recently described by his former chief speechwriter Michael Gerson as a “large-hearted man” — at least with other people’s money – indulged in an orgy of feel-good social policy. Notably there was the “No Child Left Behind Act” of 2001, which vastly increased the federal government’s intrusion into education without noticeable positive results and the Medicare Part D of 2003, which was also hugely expensive since it lacked effective cost controls. The largeness of Bush’s heart even extended to his Congressional colleagues, whom he allowed to carry on veto-free in an orgy of pork-barrel spending and outright corruption without precedent in the history of the Republic.

Even Bush’s tax changes had little or no supply side effect. His 2001 bill lowered top rates of tax only modestly, while including so many sops to populism that its effect was at best that of an equivalent sized Keynesian stimulus. In 2003 he passed a genuinely supply side measure, reducing the top rate of personal tax on dividends to 15% and thus their total taxation to around 50% from the exorbitant corporate plus personal rate of 61% they had previously borne. Even then, he did it wrong; he should have made dividends fully tax deductible at the corporate level, which would have leveled the playing field between different types of investors and removed almost all the incentives to business tax evasion. If he had done that, paying for it by capping the deductibility of home mortgage interest at around $10,000 per annum, and perhaps closing a few other corporate tax loopholes, he would have truly have increased the value and productivity of US business, while quelling the speculative boom in housing that is proving so unbearable to unwind.

Now Bush is running into the next downturn proposing a mindless Keynesian fiscal stimulus, with an unrealistic economic forecast of almost 3% economic growth in 2008 and 2009 and deficits in those years at close to record levels. Since the swing in the budget deficit from 2000 to 2004 was over $600 billion, and the US economy is bigger now, it seems inevitable that the bottom of the recession will see a federal budget deficit of over $1 trillion, with all the financing difficulties and economic distortions that will cause. In short, whatever the size of George W. Bush’s heart, it is clearly bigger than his brain.

As the primary season has proceeded, we are beginning to see into the future. The picture is not entirely negative. On the Republican side, the likely winner is John McCain, a man with innumerable drawbacks and unpleasantnesses but one pretty solid virtue: he appears to be more fiscally responsible than the incumbent, harking back beyond the supply-side showboating of the 1980s (which was always to some extent smoke and mirrors as far as fiscal balance was concerned) to the successful budget-trimming Presidency of Gerald Ford. McCain’s solution to soaring medical costs is to reduce them through increased competition; his solution to expanding the military is to reduce the gold-plating and log-rolling in the Pentagon. Faced with a trillion dollar deficit, his likely solution would be to cut back spending sharply and impose a swingeing tax increase; faced with inflation rocketing into double digits his likely solution would be to fire Ben Bernanke. One can live with such an approach, uncomfortable though it would be.

On the Democrat side, the picture is less clear. Hillary Clinton, the front-runner, appears to have her husband’s vice of sharp practice without his virtue of fiscal prudence. While she might save some money in Iraq she would spend all of it and more on social programs. Faced with a trillion dollar deficit, her twin solutions would doubtless be to impose a tax increase that was as redistributive as possible, albeit with loopholes for her campaign donors, and to hire Wall Street to push the envelope of deficit financing techniques through securitizing the Washington Monument. Double digit inflation would be pushed into the future and blamed on others, as it was from 1973-79.

Then there’s Barack Obama. On the surface, his policies are almost as expensive as Clinton’s, though he might be more determined in reining back overseas military adventurism, thus achieving a larger saving there. On the other hand, his principal economic advisor Austan Goolsbee is a senior business professor at the University of Chicago, so presumably has a good economic grasp. Interestingly, Obama has now been endorsed by Paul Volcker, in 1979-87 the only really useful Fed Chairman ever, who killed (but alas not permanently, thanks to his feckless successors) the double digit inflation of the 1970s. Assuming Obama listens to his advisors and the most eminent of his supporters one can thus have some confidence that his solutions to a trillion dollar deficit and double digit inflation would be intelligent, but not what they would be.

Looks like a two out of three chance for a decent solution, or thereabouts. But even minimally competent and forward-thinking economic management, in both the administration and the Fed, would have avoided the problems in the first place.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)