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January 30, 2002, 8:45 a.m. The Budget Battle Begins A State of the Union review.

resident Bush began his State of the Union speech with this grim assessment: “Our nation is at war. Our economy is in recession. The civilized world faces unprecedented danger.” Pausing, he went on to emphasize, “We have never been stronger.” The rest of the speech was an elegant, general discourse of what is at stake and what needs to be done.

The president identified the security of our nation as the overriding priority. First, he said we must win the war on terrorism. Second, we must protect the homeland, and third, we must revive the economy. All three objectives were closely intertwined in his speech. To win the war and protect the homeland, the nation must be strong. For the nation to be strong, the economy must be strong.

While the speech was not a detailed budget wish list, there are definite budget implications. The president specifically called for the biggest increase in defense spending in two decades and more money for the new function of homeland defense. Using the theme of “jobs,” he listed changes he thought would help revive the economy. He stressed the need for “sound tax policy” and asked Congress to make the tax cuts passed last year “permanent.” He also asked for expanded unemployment and health benefits.

The president did caution the Congress to act in a fiscally responsible manner. Provided Congress restrains spending, deficits will be small and short-lived with little potential harm for the long run.

What economic ramifications will the President’s speech have? Spending on defense and homeland security is necessary to fight terrorism and to reduce domestic anxiety so that life can return to normal. Beyond that, reviving the economy will depend on picking the right fiscal tools. If the president keeps emphasizing jobs and investment, chances are better that some good will come out of a stimulus package. That approach would lead to further cuts in marginal tax rates on the factors of production. However, if the package looks to give people more money to spend, more harm than good could result.

Wednesday’s financial-market response will give an initial read on whether Wall Street thinks the president is leading the nation in the right direction. We suggest keeping one’s powder dry until we see what Congress comes up with.

— Aldona and Gary Robbins operate Fiscal Associates, an economic consulting firm in Arlington, Va. Both are Senior Research Fellows with the Institute for Policy Innovation in Lewisville, Tex.