NEW YORK, Nov 29: Exploding federal debt has resurrected decade-old fears that the US government’s budget woes will undermine a fiscal recovery for states and cities.

State treasurers returned home this week from a conference in New York City with a two-pronged warning from Robert Hormats, vice chairman of Goldman Sachs International.

Unprecedented federal borrowing could drive up interest rates and in turn choke off the job creation that states desperately need for their own revenues to grow, Hormats said.

The unchecked appetite for cash could also begin to crowd smaller and weaker borrowers, namely states and cities, out of the capital markets, Hormats added.

In practice, this means cities and states would have to pay much higher interest rates than they would otherwise for their borrowing. Consequently, they would borrow less.

The Congressional Budget Office projects an all-time high federal budget deficit of $480 billion in the current fiscal year that began on Oct. 1.

“Almost no economist believes growth will bail us out of these deficits, so we are condemned to these deficits for a very long time to come,” Hormats warned at the conference sponsored by the National Association of State Treasurers.

Concern of federal crowding out has been around for decades. It waned in the 1990s along with the deficit, which peaked in 1992 at $290 billion. The budget picture improved the next eight years, culminating in a $236 billion surplus in 2000 and a $127 billion surplus in 2001.

The federal budget picture has deteriorated rapidly in the last two years and even White House projections do not call for a dramatic improvement any time soon.

Nonetheless, many analysts are not concerned about “crowding out” in the current environment.

The supply of investable dollars has kept pace with new bonds sold so crowding out is unlikely, said Anthony Crescenzi, chief bond strategist at Miller Tabak & Co. in New York City.

The Federal Reserve has allowed rapid growth of the US money supply and the flow of foreign money into the United States has been strong as well, Crescenzi said.

“It is a situation that could persist through 2004,” Crescenzi said.

Soaring debt in Washington is nonetheless bad news for state and local governments because it makes federal officials more stingy with the aid they dole out.

“My concerns are on the budget side,” said John Hallacy, a municipal bond market analyst at Merrill Lynch. —Reuters