By Andy Sullivan and Richard Cowan
WASHINGTON (Reuters) - The battle over the federal budget has ended. Now the war begins.
The debate over this year's budget that took the government to within an hour of a shutdown is only a dress rehearsal for bigger spending clashes to come.
Within weeks, the government will bump up against the limits of its borrowing authority and will require congressional action to avoid a debt default that would roil financial markets.
At the same time, Republicans in the House of Representatives are targeting bigger game in their budget plan for the next fiscal year, which starts on October 1.
Their proposal would slash taxes and overhaul Medicaid and Medicare, government-run health programs for the poor and elderly. It is likely to be rejected by the Democratic-controlled Senate, setting up another showdown between the two chambers.
That fight could last well into the 2012 campaign season, when President Barack Obama, one-third of the Senate and the entire House will face voters.
The budget deal agreed on Friday, if it passes Congress next week, would amount to the largest domestic spending cut in U.S. history.
That's a victory for Republicans who won control of the House in November on a promise to scale back the government and take a bite out of recession-bloated budget deficits that have hovered around 10 percent of GDP in recent years.
But the size of that cut, $37.8 billion, is less than the amount the federal government spends in four days.
Even as the government stood on the brink of a shutdown markets largely shrugged, because the Treasury Department still would have been able to issue and service debt.
TIME FOR MARKETS TO PAY ATTENTION
Investors will be watching the next fight more closely.
Treasury Secretary Timothy Geithner estimates the government could hit its current debt limit of $14.3 trillion by mid-May and has warned failure to raise it would be "catastrophic." Treasury could employ a variety of tricks to avoid defaulting for several weeks, but eventually it would run out of options.
An increase of at least $1 trillion is needed to keep the government running through the end of fiscal year on September 30, according to a Reuters analysis. To last until the November 2012 election, the increase would need to be well over $2 trillion.
Raising the debt ceiling is always a politically difficult vote no matter the circumstances, but it will be a heavier lift for Republicans. Facing pressure from fiscally conservative Tea Party activists, they say they will not vote to raise the debt ceiling without significant concessions to slow government spending further.
That could force Treasury to spin its wheels for months while Congress works out a solution, said Ethan Siegal, a policy analyst with The Washington Exchange, which tracks political developments for investors.
"We do not know how that deal will be reached, or when it will be reached -- just that we believe a deal will be reached and that it will be very ugly," Siegal wrote in a research note on Thursday.
Next year's budget debate will not be pretty, either.
Democrats have already promised to block the Republican proposal to give states control over the Medicaid health program for the poor and turn the Medicare health program for retirees into a voucher system.
Democrats also have criticized House Budget Committee Chairman Paul Ryan's refusal to end tax breaks for wealthy oil companies or to propose other tax increases that many budget experts think are necessary to solve long-term fiscal woes.
And there will be a chance to reprise the recent fight over domestic spending, which focused largely on the discretionary programs whose funding levels are set by Congress each year.
Ryan is seeking another round of deep cuts in that area, which encompasses education, law enforcement, aid to the poor, and space exploration, but represents only about 14 percent of the U.S. annual budget.
In his plan for the 2012 fiscal year, Ryan would slice approximately $80 billion from those discretionary programs, while increasing defense spending about $28 billion.
"This is a big hit on non-security spending" on top of cuts already achieved this year, said one budget analyst and former White House budget official, who asked not to be identified.
The House could vote on Ryan's budget blueprint as soon as next week.
(Editing by Mohammad Zargham)