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Irwin Stelzer: Looking for compromise in dire economic straits

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Irwin Stelzer

Reality bites. Well, not quite bites. Bares its teeth. And is ignored. President Obama and his Democratic Congress feel especially entitled to a bit extra of the bubbly now that health care "reform" seems to be certain to pass. Enter Scrooge -- or reality.

Yes, the economy is on the mend. Job losses have abated, manufacturing production rose a healthy 1.1 percent in November, new building permits jumped some 6 percent, and retail sales are coming in better than expected.

Unfortunately, memories are short. The crisis was caused in part by excessive debt: Mortgages that could not be repaid; credit card balances that consumers could not cover; property loans based on inflated values. And the solution being proposed is more debt: massive government borrowing.

The economy is floating on a sea of credit, with government deficits in the first two months of this fiscal year exceeding those run up last year, over 80 percent of the mortgage market supported by the government, and the Federal Reserve Board printing so many dollars that fears of deflation have been replaced with a gnawing worry that it is inflation that will prove the enemy -- although not of the investors stocking up on gold and gold-related assets.

Inflation at the consumer level was relatively tame, but wholesale prices rose last month by an unexpectedly large 1.8 percent (a big 0.5 percent bump if we exclude food and energy, of relevance to those who neither eat nor drive nor heat their homes).

Worse still, the president is urging banks to lend more freely to businesses that the bankers deem unlikely to be able to repay, and government agencies are financing mortgages at 97 percent of the value of the homes being bought.

So there will be blame enough for all when reality bites. And it will. The federal government deficit, $1.4 trillion, is close to 13 percent of gross domestic product. It shows no sign of abating.

The health care plan will cost well over $1 trillion, and since no one really believes that half of that will come from eliminating waste, it will eventually add to the deficit. The House of Representatives, in a pre-adjournment spasm, voted to provide billions for what is in all but name a second stimulus: more infrastructure spending, more cash to the states.

The president is stomping the country in support of still another spending program -- cash for caulkers to subsidize insulating homes, and more support for green energy production. Then is there is the $30 billion to $40 billion annual cost of the Afghanistan surge.

Never mind that the rating agencies are warning even triple-A rated countries -- most notably the United States and the United Kingdom -- that their ratings will be threatened if they do not get their balance sheets in order. That reality has not yet bitten the administration.

There is talk in Washington of a bipartisan commission to review the entire fiscal situation, including the looming bankruptcy of Medicare and Social Security. But Democrats are determined to cover the deficits by raising taxes, while Republicans insist on cutting spending.

So far, there isn't much talk of compromise, perhaps because the president says he will bring the deficit down to 5 percent of GDP by 2012. That assumes very rapid economic growth, hitting 5.1 percent in 2011, and very low inflation. Believe that, and I will get you a date with the tooth fairy.

My own guess is that a deal will eventually be cut. Democrats will accept some limits on increases in spending, and Republicans some increases in taxes, most likely in the form of a value added tax, a form of sales tax on goods and services at every stage of production.

Democrats like the idea of us becoming more like Europe, and know that VAT is a very easy tax to raise, and Republicans prefer taxing consumption to raising marginal income tax rates. Besides, by waiving VAT on exported goods, as Europeans do, we will be able to provide a covert subsidy to exports without running afoul of World Trade Organization rules.

Not as good as slashing spending, but a darn sight better than a rating downgrade.

Examiner Columnist Irwin M. Stelzer is a senior fellow and director of the Hudson Institute's Center for Economic Studies.

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