Reality bites. Well, not quite bites. Bares its teeth. And is ignored. During this holiday season President Obama and his Democratic congress feel entitled to an extra glass or two of the bubbly now that health care "reform" seems ever more likely to pass, the threat of financial collapse is past, and the economy is in better shape than it was when Barack Obama was inaugurated in January of this year.

Enter Scrooge -- or reality. Yes, the economy is on the mend. On the mend, but not quite mended. Job losses have abated, and there is reason to believe that the next report will show modest hiring gains. Manufacturing production rose a healthy 1.1% in November, due in part to restocking. Construction of new homes rose smartly in November, by 8.9%, and the number of building permits issued jumped 6%, to the highest level in a year. Retail sales are coming in better than expected. On a trip to New York last week I couldn't help noticing the crowds at the counters in high-end stores -- these more often than not included many foreigners, feasting on the buying power conferred by the depreciated dollar. The official U.S. position might be that we favor a strong dollar, but where the cash meets the register and the credit cards the swipe machine, a strong dollar is the last thing merchants want to see.

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 topping $1 trillion, over 80% 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 a worry of the investors stocking up on gold and gold-related assets. Wholesale prices rose last month by an unexpectedly large 1.8% (a big 0.5% 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% of the value of the homes being bought. Those loans aren't exactly of the highest quality.

To avert eyes from the mounting deficits, the President is attacking "fat-cat bankers." Not without reason. Having called on the taxpayers to save their hides, the banks have returned to profitability, in good part because they can borrow at low rates because of the loose monetary policy needed to prevent the economy from having a relapse. But instead of using the profits to shore up their balance sheets, the bankers are throwing a bonus-fuelled holiday party for themselves. To do that, of course, they had to get out from under government supervision by repaying the loans the government extended. That meant selling shares to raise capital, diluting their existing shareholders. In short: the bank executives diluted their shareholders in order to raise money with which to buy out of government supervision of their bonuses.

So there will be blame enough for all when reality bites. And it will. The federal government deficit, $1.5 trillion, close to 13% of GDP, 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 $175 billion 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. He also traveled to Copenhagen to promise America would bear its share of the trillions of dollars the rich countries are preparing to transfer to poorer ones, much of which money will end up in Swiss bank accounts after a very brief visit to the intended beneficiaries. Then there is the $30-$40 billion annual cost of the surge in Afghanistan, which has not yet been included in the budget or counted against the deficit.

Never mind that the rating agencies are warning even triple-A rated countries -- most notably the US and the UK -- that the ratings of their sovereign debt will be threatened if they do not get their balance sheets in order. Or that such a downgrade would mean higher interest rates and an aborted recovery. The spending continues, the borrowing continues, the red ink flows.

Congress will undoubtedly hear from constituents during the recess. The vast majority want the deficits brought under control, and oppose health care "reform", which they know will drive up their insurance premiums. Diana Furchtgott-Roth, my colleague at the Hudson Institute think tank, estimates the increase at over 40% for families who get health care insurance through small businesses.

There is talk in Washington of a bipartisan commission to review the entire fiscal situation, including the looming bankruptcy of the Medicare and Social Security systems. Traditionally, Democrats want to keep spending and cover deficits by raising taxes on high earners, while Republicans favor cutting spending. So far, there isn't much talk of compromise, perhaps because both parties are waiting to see how President Obama plans to implement his pledge to bring the deficit down to somewhere around 4% of GDP by 2019, which will still be high by historic standards.

The assumptions underlying the president's deficit-reduction program are, to put it mildly, questionable. His forecasts assume very rapid economic growth hitting an annual growth rate of 5.1% in 2011, and very low inflation. Believe that the economy can achieve those goals only one year from now, and I will get you a date with the tooth fairy.

My own guess is that deal will eventually be cut by a bipartisan commission. Democrats will accept some limits on net, new spending, and Republicans will accept some increases in taxes. That will most likely take the form of having the U.S. join almost all other countries and impose a Value Added Tax (VAT). Set at 20% in most European countries, VAT taxes goods and services at each stage in the production process. Democrats, especially the president, like any idea that makes us more like European welfare states, and know that VAT is a very easy tax to raise; it has champions in House Speaker Nancy Pelosi and key Democratic adviser John Podesta, even though it is difficult to build in features that prevent it from being regressive. Republicans like VAT because it is a consumption-based tax, the adoption of which would ease the pressure to raise marginal income tax rates, and might take the steam out of the drive to restore the inheritance tax, which Republicans loath despite the fact that it merely taxes the winners of the sperm lottery. Besides, by waiving VAT on exports, as Britain and other countries do, we will be able to provide a covert subsidy to exports without running afoul of World Trade Organization rules.

Irwin M. Stelzer is a contributing editor to THE WEEKLY STANDARD, director of economic policy studies at the Hudson Institute, and a columnist for the Sunday Times (London).

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