“The big budget issue is the longer-term structural entitlements challenge staring us in the face.” Treasury Secretary Paulson

In bridge, one must often exit winning one last trick, and then give the defense a chance to lead, so that you can trump high cards and get back in control of the hand. I don't know if Paulson plays bridge, but it certainly sounded like it in his remarks earlier this week. What commentators economic and political realized was that Paulson's reason for giving the speech was to promise that the Bush executive would, starting next year, gut entitlements to deal with the budget problem.

It represents a fundamental shift in outlook, the Republican leadership was willing to spend, as long as spending helped win elections. It also tells elites what this election is "about", what issue currently blocked in Congress is being decided. If the Republicans win, they will take on Medicare and Social Security, and it will be harder to stop them.

The reason that Paulson's remarks aren't credible is two fold. First his call for Sarbanes-Oxley being watered down doesn't bear on reality very much. The reason equity listings are going overseas is that the premium prices charged by US IPO houses - often significantly above IPO costs in other countries - is no longer justified by the difference in access to capital. In a global market place, premium prices must be matched with premium service. But in US markets the "pop" which investors love from an IPO, is pain to the company seeking funds, afterall, if someone else could sell it for more, why didn't you?

While this doesn't bear directly on entitlements, it shows that Paulson is now engaged in the rather tiresome misdirection that is the standard operating style of modern Republicanism, point to a problem and then get permission to do something completely different. Such as invade Iraq to solve the Al Qaeda problem, or cut taxes on the rich to deal with the employment problem. The list can be extended indefinitely, though the funniest one is to ban Darwin to solve the economic problems of the agricultural heartland.

The other reason why Paulson is not credible on this issue is the very nature of the attack. He first admits that this economy has not been generating the gains in wages and wealth for many that previous expansions have. Several economic commentators, myself included, have made this a bread and butter topic over the course of the Bush executive. Real median wages, real disposable income, household savings - that is the measures of how well the vast majority of Americans are doing - have been in the toilet most of the expansion. Job creation has been feeble compared to the post-war period.

Paulson knows that a large reason for this is loss of competitive advantages. I know he knows this because at Goldman-Sachs his team backed numerous visionary and important sectors, such as biomass energy. However, as a member of the Bush team he isn't going to say "we need to take windfall profits and turn them into social surplus," he is going to say "we need to gut Social Security and Medicare". The same thing is being tried on the state scale here in Massachusetts, were a Republican lt. governor running for the top job, who got financial aid in college, had a disabled vet for a father, and has received numerous other government program helping hands - is promising to gut state pensions in order to pay for a few cents off a gallon on the gasoline tax. Pull the rope up behind you Republicanism is alive and well.

However, there's no connection between the two. In fact, the ordinary person won't on net, see any advantage at all, because it is payroll taxes that pay for Social Security and Medicare - that is the amount of redistribution from the upper classes is tiny, tiny, tiny. On the other hand, brokerages like Goldman Sachs will make a killing if trillions of dollars of really dum money enters the system, and if the average American becomes adverse to restructuring ordinary treasury bonds because their retirement is locked in them.

In short, what Paulson is pushing is class civil war, where one half of the poor needs to be convinced to kill the other half of the poor. Boss Tweed had faith in this maxim, and obviously the current Republican Party does too.

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What this represents, however, is a clear decision by the Republican Party to accept that 2008 is going to be the year they lose nominal power. Their hope is that by driving a stake through the liberal state now, they will make it so that the Democratic tenure will be dominated by cleaning up after the massive debt the leave behind, the failed war in Iraq, and the destroyed state of the US dollar. And when that is done, the country will be ripe for the next snake oil salesman to come along and say "what you need is a wild night of tax cuts and war spending!"

It is true that long term committments on Medicare and Social Security are where the failure of the US economy over the last generation to generate real wages is visible. It is where stagnation shows up in the numbers. We have two choices, we can either continue to burn the house down to toast marshmellows - that is continue to accept stagnation so long as it comes with McMansions and F-150 trucks and the occasional war porn orgy running on Fox News - or we can decide to create real growth again. By this measure we have not been doing well for a long time, and it has been so long that we have even built it into our economic numbers.

The Republicans are offering the first road - mug granny to fill your gas tank - and have no credibility on offering plans in the future. No substantial economic work has been done since last year which would change what the Republicans are going to propose - basically, cut Social Security and hope people can make up the difference on the stock market. I leave it as a class exercise to see what would have happened to money pulled out of Social Security and put into the S&P 500 in 2000. Or you can just look at the British pension crisis, where Thatcherized national pensions are now in crisis.

Government will still be big under this plan, it is just that it will be a big bully, confining itself primarily to stealing oil and debt collection.

The Democrats, however, have not offered the second road. The status quo doesn't work out very well either, as an aging population and shrinking real wages combined with borrow and squander policies have now forced the isssue. Bush has largely wiped out the progress Clinton made on the debt, just as his father and Reagan wiped out the progress made since Eisenhower.

There are only three solutions to debt. One is to try and inflate the debt away, this is "the inflation tax", where holders of debt and currency lose buying power, in order to give buying power to those who have access to cheaper dollars to pay back debts. This isn't all debtors, it is debtors with pricing power. If you can't get a raise, this does not mean you. The second way is, of course, to accept a lower standard of living and pay back more money. The public is willing to do this in theory - that's what the polls say - but is never willing to elect a Congress to do it. The third way is to grow the economy and make the same debt easier to pay.

This third way works when a country is not adding substantially to debt, and is saving a great deal in order to invest. But it doesn't work if a country is both increasing its public debt, and its trade deficit, at the same time. After all, one way to grow the economy is to invest in other countries and have the income from that investment used to pay off debt held by others. This was the strategy during the Bretton Woods era, and why the US focused on "Gross National Product" rather that "Gross Domestic Product".

To pay off the debt by cutting, one has to go where the money is. There are only three places. One is interest on the debt itself. By managing the debt well, the Clinton Administration cut the costs of borrowing, but this is only on the margins. The second is the defense budget and the war on Iraq. The third is "entitlements" - medicare and social security. Domestic spending ex-defense doesn't amount to enough, even if we slashed and burned every popular program. The other road is to increase taxes.

Since, again, Americans vote for ever bigger defense budgets, and are willing to vote endlessly lower taxes on the rich in the foolish hope that the rich will tinkle down some of that money - that means that the only way to solve the debt problem by cutting is to rob retirees. Corporate America is doing it - as medical benefits are cut, pensions cleaned out in bankruptcy court, and defined benefit pensions closed to most workers - and Paulson now thinks that it is time that Washington DC do the same. However, he knows that the current Congress - which has the largest Republican majorities in decades - doesn't have the mandate to do it. He knows what is being said around Washington now, that we need to hold an election on this.

Paulson's remarks are important, because when people in Washington say "we need to have an election" about something, the really do believe that to the victor will go the spoils. And in this election, your social security check is now officially the spoils. What makes it doubly important is that the economy, to date, has been sustained by the housing boom and federal spending. This means that to cut the budget deficit in the face of an economic slow down, whether by cutting entitlements or by cutting other spending, could send an economy that is under pressure into full blown recession.

In fact, the failure of the Federal Reserve to fight inflation may well be creating a policy pressure to cut more out of the Federal budget and to tighten interest rates, even in the face of a slowing economy. This would mean that instead of Keynesian counter-cyclical policies - where the government acts to cool a hot economy, and heat up a cold one - will have been replaced by policies which pour gasoline on a hot economy, and then stiffle a cold one.