American Enterprise Institute

January 30, 2006

[Unedited transcript from audio tapes]

8:45 a.m.	Registration and Breakfast
9:00	Panel I: Foreign Policy
Speakers:	Thomas Donnelly
	Reuel Marc Gerecht
	Roger F. Noriega
	Danielle Pletka
	Gary Schmitt
10:00	Panel II: Economic Policy
Panelists:	Kevin A. Hassett
	Phillip L. Swagel Norman J. Ornstein Joseph A. Antos
Moderator:	James K. Glassman
11:00	Adjournment

Proceedings:

Panel I:  Foreign Policy

MS. PLETKA:  Good morning.  I'm Danielle Pletka.  I'm the vice president for foreign and defense policy studies here at the American Enterprise Institute.  I feel like I'm on an airplane--we're here for a State of the Union event, and if you're in the wrong place, you probably ought to get up and leave now.

We've got two panels this morning.  The first is our foreign and defense policy experts, and we will be here for an hour.  Then our economists will stand up and talk about domestic and foreign economic issues that will be of interest.

We have only AEI scholars here today.  I am joined by Gary Schmitt, who runs our project on advanced strategic studies here at AEI; Roger Noriega, who's joined us recently as a visiting fellow, former assistant secretary of state for Western Hemisphere affairs; Tom Donnelly, who didn't join us recently, who's our national security expert; and Reuel Marc Gerecht, who is our expert on terrorism and lots and lots of other things, Iran, Iraq included.

What we're going to do is try and touch lightly on a variety of subjects, but we're going to also try and leave sufficient time for questions and answers that we can talk about, what you might be interested in and what you see is on the agenda.  Gary is going to talk about Europe and also about some intelligence matters.  Roger is going to talk, shockingly enough, about Latin America.  Tom will talk about two issues that he knows very well, first military questions and second a little bit on China.  And Reuel is going to talk a little bit about Iran, Iraq, and also terrorism and--his favorite issue--al Qaeda.

I'm going to start off for a little bit of a briefer time than everybody else and just outline a couple of very quick issues that should be front and center, will likely be front and center, but may not be front and center in quite the way they would have been had we all written the State of the Union address.

The first is the question of Iran.  It's on the front pages of the newspaper, it's gotten a great deal of attention.  There are several different parts to the question what we ought to be doing and what we are doing.  What we are doing is engaging in a favorite of the pundit community, and that is multilateral diplomacy.  Our secretary of state is meeting today--flying back for the State of the Union tomorrow--meeting today with the European Union, with the EU three, Germany, France, and Great Britain, as well as Russia, China.  And they're all talking about what to do about Iran.  The Russians and the Chinese are talking about how to bail the Iranians out of the predicament they find themselves in when the IAEA Board of Governors meets at the end of this week and when they will possibly be referred to the Security Council.

I don't think any of us is too sure what's going to happen.  But the president is clearly going to say that multilateral diplomacy is working, that in fact we've moved in a very good direction, that we've widened the circle, and that more and more countries are concerned about where the Iranians are going.

It's true, more and more countries are concerned about where the Iranians are going.  But I wouldn't attribute that to excellent diplomacy on our part or on the part of the Europeans, but instead on outrageous behavior on the part of President Ahmadinejad, perhaps the best thing to happen to our Iran policy in a long time.  It has focused our minds in the way that Samuel Johnson described a hanging focusing people's minds. Certainly our policy has not evolved.

What you may also hear is that there is every possibility that Iran can be contained.  And I would say that, as we listen to what the president says, listen carefully, because Iran cannot be contained.  Iraq was a very, very different situation.  I would say that Iraq probably wasn't contained in the years prior to the war.  Iran is certainly not going to be contained.  And if we fail to agree at the end of this week on a way forward, we are facing a very difficult situation.

Look for answers as to what the president may suggest that we do.  I don't think those answers will be there.  I don't think we have any idea what it is that we're going to do if we don't achieve a referral.  And even if we do achieve a referral, I don't think we have very much sense of where that's going to go, either.

We can talk a little bit more about that in the Q&A section, and I know that Reuel is going to talk a little bit more also about the question of what to do on Iran.

The question of Iran and what to do about their nuclear ambitions within the nonproliferation treaty also raises the issue of India.  And that is something that I imagine the president will talk about.  He's got a trip scheduled to India in just over a month, and the big issue of contention is whether or not we can have a peaceful nuclear arrangement with India.

Well, everything that we say about Iran is listened to very carefully by the Indians and by the international community that is concerned about the proliferation of nuclear weapons.  We have a policy that, the president will explain, is a very bold new policy--if he talks about this, and I think there is some possibility he will.  It is, in fact, a bold new policy.  It is a completely contradictory policy to the one that we embrace on Iran.  And how we go forward on that and how the president explains how we're going to go forward on that is something also that is very worthwhile to keep an eye on.  I think he will have a very hard time squaring the circle on nonproliferation issues.

Last but not least, an important issue is the election of Hamas last week.  Now, I hope Reuel, if he has time, will talk a little bit--and can manage to weave all of these things I've dumped onto him together--if he has time, he can talk a little bit more about this.  I only want to make one point about this, and that is that a lot of people have very gleefully pointed out in the last few days that this is really a repudiation of the president's democracy agenda.  This is the death knell for the freedom agenda, because in fact what the freedom agenda meant was the election of fundamentalist Islamist parties in countries where it is intolerable and, in essence, facilitating the spread of terrorism.

Now, people who come to events at AEI should have a strong sense that what we think of as the freedom agenda and what we believe in as the promotion of democracy has a great deal more to do with the building blocks of democracy--a free press, free formation of political parties, access to media, a whole series of other things that make up a true democracy, rather than what we've seen in the West Bank and Gaza which, I would argue, is not necessarily a mature democracy in any way.  When your main choices are to repudiate the secular autocracy with the other parties that appears to be clean, and that is the fundamentalist party, you're left with not a great deal of choice.

It's no surprise that people voted for Hamas.  It's no surprise that people turned to what they view as the cleaner party.  It may be something we can work with, and we can talk a little bit more about that, but we shouldn't view that as the end of a democracy agenda.  And I hope and I think that the president will talk more about this issue and how important it is to undercutting terrorism.  It is an important step forward.  It is in fact a way ahead in the Middle East and we should not view the victory of Hamas as an end to that freedom agenda.

I'm going to turn to my colleagues and we are going to go backwards down the line.  Gary is going to start and Reuel will wrap up.  So, thank you.

MR. SCHMITT:  Thanks, Danny.

I think I'm going first because I'm going to talk about Europe, and I suspect that if we find more than three or four lines about Europe in the State of the Union, we'd all be quite surprised--with the exception, of course, of what the Europeans may or may not contribute on the question of Iran.

In some ways, that's kind of odd, I think, because the truth is there's plenty to talk about when it comes to the state of transatlantic relations.  And in fact, I think the president can make a fairly strong case that, compared with a year ago, two years ago for sure, transatlantic relations are significantly improved.  And there's a real case to made for much of what the Bush administration has done to repair those relations.

Structurally, very important things.  I just came back from Europe, and it's perfectly clear to me from my stops in various capitals that the tensions that existed previously have greatly diminished.

The other thing I would say is that it's made a big difference that Merkel, of course, is now the chancellor in Germany.  The Germans find themselves now in a completely different game.  I think they believe that Schroeder put them in a position where they were dead-ended in a number of policy arenas.  Merkel's trips to the U.S., Russia, and France have changed that dynamic drastically, and for the first time I think the Germans feel like again they have some flexibility about how to participate on the global stage and with us.

Obviously, Chirac's implosion in France also helps.

And then finally, I think, a very understated, under-appreciated fact about transatlantic relations that's occurred, ironically, is the demise of the EU constitution.  Now, what I mean by that is, quite simply, that that's taken the steam out of a lot of the European project, and in it's place, actually, what you've seen, I think, very subtly but quite significantly, what you've seen is the rise of NATO again as being the form for strategic dialogue between us and our European partners--all of which, I think, is good news for the Bush administration and transatlantic relations.

Now, substantively, I would also say that there's good news.  The European Union and the European allies have all, at least rhetorically and officially, proclaimed that they are in fact in favor of the Bush agenda promoting democracy not only in the Middle East but around the world as well.  Now, some European countries are better at it than others and others will have to catch up.  But I think it's an important step to be recognized, that now, in fact--at least, again, formally--the European partners are on-board that agenda.

And this, combined with the fact that I think [inaudible] cooperation on counterterrorism, on a lot of proliferation issues--and I'll get to Iran in a second--suggests that in fact, to, I think, everybody's surprise, the degree to which the Europeans are on-board what I would call the Bush agenda is really quite striking and again, I think, goes under-appreciated because of the debate about Iraq.

And even on Iran I would say if you were to ask myself or my colleagues up here two years ago what we would have expected from the Europeans on the question of Iran, I would say that in fact we've seen more progress on dealing with the issue than we could have ever expected.  Now, I'm not pollyannish.  At the end of the day, I'm not sure where the Europeans will be when it comes to the hard questions that we're going to face in the year ahead.  But that said, again, given the debate over Iraq, it's really quite striking how far Berlin and Paris and London are when it comes to dealing with the Iranian regime.

The other thing I would finally say about the European agenda is that it's a very big agenda in the year ahead.  And again, I don't expect the president to talk about it, but I think it's worth recognizing that transatlantic relations are going to have some vital questions to face in the year ahead.

In no particular order, I think we're going to face more difficulties in Afghanistan, so our transatlantic partners are stepping up to some degree in Afghanistan, but it won't be enough and we'll have to ask them to do more.

We have Ukrainian parliamentary elections in late March that are going to be quite significant.

We have presidential elections in mid-March in Belarus that are going to be quite significant.

As Danny mentioned, our European partners and the U.S. are going to have to make some major decisions about how to deal with the Hamas-led government and the Palestinian Authority.

And of course, again, we'll come back to Iran.  That's just not going to go away.

So transatlantic relations, while they're not going to be a central part of the president's speech tonight, in fact are going to underlie a whole lot of our foreign policy agenda in the months ahead.

Two things I actually would like to see the president talk about now:

The first one has to do with transatlantic relations itself, and that, I think, is just this growing problem that both the U.S. and the Europeans are going to have in the years ahead with energy supplies.  Now, we already know about the energy supply problems with oil, but there's an increasing problem that's arising with supplies of natural gas.

Now, our other friends in the American Enterprise Institute, the economists, would tell me that, you know, let the market take care of this and at the end of the day it will all wash out.  But just having come back from Europe, I must say that this is an increasingly central, strategic problem for the Europeans.  And I would say it's probably going to be one for us as well.  The great vast resources of Russia with respect to natural gas has given them a new lease on life on the world stage, and also it has given them a good deal of leverage over a lot of foreign policy initiatives in Central Europe, Eastern Europe, and frankly in Western Europe.

So I think the president could do transatlantic relations much good if he began to talk to the Europeans about a new initiative to begin to figure out how to diversify natural gas resources, how to build a global market so we're not so dependent upon single-source suppliers and the like.  I think that's not only important for economic reasons, but also it's very important for transatlantic strategic reasons.

I think I'll stop there.  In Q&A, I guess, because I've probably gone on for a long time, but I would be willing to talk about the president's program on warrantless surveillance.  I've written quite a bit about this issue, and my background in fact is intelligence oversight when I worked in government both on the Hill and the White House, and I'm a defender of what the president has done, but I also think there are some initiatives the president can take to help take the steam out of the debate.

MR. NORIEGA:  Thank you very much.  Well, I don't know how many of you are like me in that I will be praying for a two-hour speech.  Because it will have to be two hours for the president to say anything about Latin America.  And with all due respect to the president, for whom I worked and for whom I have a great deal of respect, but I'm disappointed in that over the years because he has a terrific policy in-hemisphere.  And it is central, really, to the freedom agenda that he's pursuing elsewhere in the world.  I think that he has an opportunity to bolster that freedom agenda in the Western Hemisphere, and it's important that he does so.

First off, the president's put an awful lot on the table for Latin America.  He's pushed forward on a trade agenda to generate economic opportunity and growth in the hemisphere, and he has aggressively promoted democracy, the rule of law, anti-corruption efforts that are really important to spread out that economic opportunity to people from all walks of life and to tackle the essential problem that our neighbors in Latin America are confronting, which is chronic poverty.

But having said that, Bush has put that on the table, the real hard work is to be done by our neighbors in the region.  And the good news is that despite the headlines, despite some of the borderline hysteria, particularly from the media that always tries to find a way to demonstrate the United States out of step with its neighbors in Latin America, I think there is an abiding consensus in favor of that free market agenda and in favor of a democracy and, as a matter of fact, in favor of closer partnership with the United States in particular.

So I think that it's also important for Bush to bolster this agenda, to help our friends more as they do the hard work and the heavy lifting.  It is also an opportunity to show that Bush is the real populist, the genuine populist in the Americas, because he's pushing an agenda that is, first and foremost, less popular with the elites in Latin America than it is with the population in general.  And why?  Because it is about taking political power from those who have it today in Latin America and giving it to those who don't.  It's about extending economic opportunity to the very poor.  And I can understand why the elites of Latin America are no more enamored of that idea today than they have been in the last 500 years.

The president has an opportunity to push this agenda forward by advocating that Latin Americans band together, evaluate one another on how they do in terms of respect for democracy, in terms of respect for corruption, invigorate the Organization of American States to do those sorts of evaluations.  And then those people who pass the test that they're governing justly, that they're governing democratically, that they're for economic liberalization and extending opportunity to people of all walks of life, could participate in what I have referred to as an opportunity partnership and have access to a solidarity fund for infrastructure development that is really essential, for public-private partnerships, for an initiative that President Bush talked about last June to prime the pump of private-sector investment in Latin America.

So I think he can push forward on that agenda.  Also, to restate his commitment to the vision of regional trade and free trade, and deal with willing partners.  Quite frankly, I think the Brazilians have a legitimate beef--no pun intended--on agricultural subsidies.  But having said that, if they aren't willing to push forward, we need to push forward with neighbors that are willing to do so on that regional trade agenda and demonstrate that it's not done.

Now, it will be very good if the president were to hold up the January 2006 version of Latin America Outlook.  Danny Pletka has promised me a fruit basket if the president holds up this document.

[Laughter.]

MR. NORIEGA:  But that's advertisement.  It's available on the Web site and free of charge.

A second point, and an extraordinarily important one and compelling one that I hope the president would refer to, is that Castro is shuffling off the world stage and making his final arguments before the judge of history--which will not absolve him.  And it's important that the president make it very clear that the United States stands with the legitimate aspirations of the Cuban people for a genuine transition--not a succession, not a dictator passing the torch to another dictator--and that our neighbors are really going to be on the spot here, that as the Castro dictatorship shrinks into history, that the new government that steps forward has to play by the rules, the architecture of pro-democracy commitments that has grown up around the Cuban dictatorship, particularly in the last 5 or 6 or 10 years.

So it's important that the integration of Cuba into the economic and political partnership in the hemisphere be based on Cuba's total commitment and compliance with the commitments of the Interamerican Democratic Charter.  And I think the president should make it very clear that we are [inaudible] for a genuine democratic transition, not a succession between dictators.

And finally--well, not finally, but another point I hope the president refers to is immigration.  This isn't exactly foreign policy, but for me it frankly is.  And quite frankly, it's important the president remind the American people that the Western Hemisphere is home to three of our four largest energy producers.  It is home to our fastest-growing economic partners.  And quite frankly, a wall is a very ugly thing when you're talking about building an interamerican community.  I think the president should find a polite way of saying that the House version of the immigration bill is all about fear.  Fear is not an American trait, not one that we inherited from our forefathers, whether they came over on the Mayflower or the hundreds of millions who are the sons and daughters of immigrants who built this country and who are still building this country.

So I hope the president says that we need to have immigration reform that balanced, that definitely talks about securing our border, all of our borders, but that also recognizes the economic importance of immigrants to the future of this country and finds a way to accommodate them.  And the president should simply say that he will work for a bill that is comprehensive and addresses that essential point of accommodating labor in a legal way and he will work against a bill that is not balanced.

Finally, on energy, I think it's very important that the president note that we could be self-sufficient in this hemisphere in energy if the countries get the policies right, and that it will be the policy of the United States to work with the private sector, to work with our partners in the region, to get the policies right in energy.

Thank you.

MR. DONNELLY:  I have to discuss two topics, but I have to discipline Roger as well.  I will try to get through both the question of China and the question of our defense policy in the next five minutes.  So if I skim over, you'll forgive me.

I'd like to begin first with China.  Actually what in my mind ties both these two subject matters together is that, at least in my judgment, these are the two most important areas where the Bush administration has failed to resolve the contradictions that it inherited from the Clinton administration and is likely to leave behind for its successor a situation that's far from healthy.

But to begin with China.  And again, my purpose is not to blame this administration.  The difficulty of dealing with China in a post-Cold War context goes back now a good 20 years, almost.  But the thing that's changed is, obviously, China's accelerating geopolitical importance, it's economic rise, and, not least, its acquisition of very serious military capacities not only for the purpose of, say, intimidating Taiwan--although that still remains sort of mission no. 1 for the People's Liberation Army--but also for confounding our ability to project our own military power not only in the West or in the Pacific but, increasingly, in other parts of the world.

So I want to underscore the fact that China's rise in all these dimensions is actually a global phenomenon and one that's been accelerating faster than various American administrations, and particularly this administration, have been able to keep up with.  I just want to tick off a number of areas where China's global role is confounding our own efforts, and I'll begin with Latin America.

It's no accident that newly elected Bolivian President Evo Morales talked extensively during his campaign about the desire to establish relations and a partnership with China explicitly as a way of counterbalancing American power in the region.  He's following Hugo Chavez's model in that regard.  And it's something that we should be--not hysterical about, but take quite seriously, particularly when it comes to energy issues.

Likewise in Africa, where we have seen a similar phenomenon when it comes to Robert Mugabe in Zimbabwe, and China's sponsorship of the regime in Khartoum has been a key factor in allowing that genocide to continue without serious interruption over several years now.

Most crucially, China's involvement in the Greater Middle East is something that gets very little attention but, in my mind, is the most possibly catastrophic event that one can imagine in the decades to come.  China's interest in the region geopolitically, and in particular because of energy issues, is rising substantially.  Its ability to influence people in the region is likewise rising.  I don't want to steal Reuel's thunder very much, but we have to understand the problem with Iran very much through a Chinese lens as well as through our own lens.  If we intend most immediately to try to do something in the U.N. Security Council to try to stem Iran's development of nuclear weapons, it's not so much the Europeans we have to convince as it is the Russians, but most particularly the Chinese.

And lastly, we shouldn't forget China's role in East Asia, which remains the most economically dynamic part of the planet.  It's a place where the freedom agenda, so called--again, even preexisting this administration--has been an enormous American success story.  The notion that our political principles and devotion to democracy is something that's simply a Western cultural phenomenon has been, I think, fairly thoroughly undercut by the development of robust, even rather raucous, democracies in places like Taiwan or Japan, and, again, where I would regard the test of the Bush doctrine and the freedom agenda to be open-ended and certainly worth continuing to peruse, but which obviously runs afoul of our need to deal with China economically and in many other ways.

So the fundamental conundrum of how to deal with a rising China, with which we trade but which might prove an adversary to the United States, remains for a future administration, just as it was on the plate for President Bush when he took office.

Quickly on defense matters.  Whatever the president says in the State of the Union speech will only be an introduction to the Quadrennial Defense Review that will come out over the weekend.  This is, depending on how you count them, the fourth or fifth strategic military review conducted in the post-Cold War world, and I'm beginning to think that we should end the process rather than trying to mend it--to steal a phrase from President Clinton.

Based on what I've been told by the Pentagon and observing the process over the last year, the document per se may actually provide a margin of strategic clarity for the Defense Department, but I can never remember the degree to which the engine of strategy or the levers of strategy are disconnected or if they're more disconnected from the mechanism of budgets and force structures.  I won't go into details, but I will just sort of refer everybody to the debate over the thin green line over the last week or so.

President Bush has committed us to what we're now supposed to call the long war in the Middle East, which is most certainly not a war of firepower featuring dogfights or naval battles, in large measure, but will be determined by our ability to project and sustain land force in the region.  For reasons that I'm simply unable to understand, this president and this Pentagon have chosen not to increase the size of the American land force and particularly the size of the America army and to go forward on the assumption that our experience in Iraq over the last three years is simply an anomaly that will eventually go away if we stare at it long enough.  They were telling us this in 2003, when the insurgency began.  They continue to advance this rationale for choosing not to increase the size of the land force.

They are doing wonders, actually, to make the soldiers that we do have more effective, but just to conclude with one rather glum statistic:  The level of effort that we have sustained in Iraq and Afghanistan, the sort of number of American marines and soldiers who are out there on a daily basis, totals up to the number of 18 brigades.  We have not ever really gone below that threshold.  Now, the rule of thumb for power projection is you need three times the number of folks in the service in order to maintain one soldier or one marine deployed forward.  And I am not a mathematician, but 3 x 18 is still 54.  The current plan, the Defense Review Plan, actually the long-held plan by the U.S. Army is to maintain, actually increase its structure to have 33 brigades on active duty.  Any way you look at it, 33 is less than 54.

That means, at the very least, that the burden that folks in the National Guard have borne over the last couple of years is not likely go away.  But really, more importantly, more important than the burden on the force per se, is that one of the possible paths to victory--that is, committing a larger force to the region--is really highly risky and simply off the table.  We could surge at time of crisis and put more bodies out the door, more units out the door than we are now, but we could not sustain it.

So our approach to the Middle East is fundamentally constrained by the choice to keep our ground forces small.  And again, I think that will be a legacy not only of this Quadrennial Defense Review, this State of the Union speech, but of this administration at 2008.

MR. GERECHT:  I'll be very quick here even though I've got at least four or five points here.

I'm sure the president is obviously going to mention Iran in his State of the Union address.  The real issue, though, is not, I think, discussing the nuclear question, because the nuclear question, I think, has a sort of logic of its own now:  Either the Iranians are going to go back to the negotiating tables for whatever purposes they may have, or they're not.  And then you get to test the mettle of the Americans and the Europeans.

The real issue, I think, is whether the United States is actually going to seriously back democracy promotion and regime change.  Bob Kagan had a piece in the Post the other day, and I thought it had a very nice title, where it says, you know, it's the regime, stupid.  I mean, that's what it is.  I mean, the United States doesn't at this time really have a very serious overt or covert democracy promotion program for Iran.  If you were to make a historical comparison of the 1980s, when we were really seriously only worried about Iran being a terrorist state and destabilizing the Middle East, we did have a--not particularly vigorous--but we did have an extant democracy regime change program that had covert elements to it.

Today we have essentially the same issue.  Iran still supports terrorism, it still would like to cause trouble in the Middle East, and it is on the verge of getting nuclear weapons, and we do not even--cannot come to the sort of moral or strategic conclusion that we should have a democracy regime change program.

That is what you should look for in the speech, the extent that he talks about that and, even more importantly, the extent that Secretary Rice talks about it later.  I suggest to you the way you can have a litmus test is if you hear any discussion among senior officials about, you know, the parallel to Hungary in 1956 or containment in South Africa; that means the Bush administration has no intention of becoming serious about democracy promotion inside of the country.  If one had to take bets, you would have to bet at this moment that they're not ready to become serious about that.  And unless you see some covert part of this program, I suggest to you, you really don't have a program, because overt democracy promotion in a country like Iran simply doesn't have sufficient teeth.  You must have an overt side but you also have to have a covert side, considering that the regime is quite adept at harassing, arresting, and murdering individuals that are serious opposition.

Iraq, I think, is more or less on autopilot, which is what you would expect it to be.  I mean, the Americans and the Iraqis are either going to be successful in developing a real counterinsurgency strategy using Iraqi forces as the bulk of that effort--I think we're not going to see, obviously, any significant increase of American forces in Iraq--or they're not.  The political evolution is going forward.  I think it's going reasonably well.  It's far from ideal, but it's what you would expect.  It is working.  It's bringing in both, I should say, the Shiite, the Kurdish, and even now the Sunni communities.

I would put a little provision or warning out there:  It's an illusion to believe that this political process is going to solve the insurgency--I think the only thing that's going to solve the insurgency is an effective counterinsurgency strategy--and it's not going to go away anytime soon.  And the notion that you're going to bribe and buy off the Sunni community, I think, is a misnomer.  The Americans may try to go down that path, but it won't be terribly successful.  Neither the Shia nor the Kurds will allow that to happen, so we'll sort of bang our head against the wall if we go that direction.

But I'm reasonably optimistic that the worst of what I call the Sunni Stockholm syndrome is over, if for no other reason because we have to continue to build up the Iraqi armed forces.  I think everyone realizes now that you're not going to have a decisive contribution by the Sunni community in that effort.  The majority of that is going to have to come from the Shia and the Kurds.

On al Qaeda, again, I think this is sort of on autopilot.  I think the administration has probably done a much better job than people want to give it credit for.  I disagree quite strongly with my good friends Daniel Benjamin and Steven Simon in their book, "The Next Attack."  I don't think you're losing the war on terrorism.  At least you're not losing the war against al Qaeda.  I mean, I would expect them to try to do more of the type of Predator drone operations in the future.  I don't see any other choice.

You know, the regimes in place in the Middle East are either going to help us because they fear us, or they fear al Qaeda, or they won't.  Because they don't fear us and they don't fear al Qaeda.  If they do, then you'll continue to have necessary liaison cooperation.  My greatest concern is actually we exaggerate the value of that liaison cooperation, that we have a tendency to look upon Egypt or look upon Jordan and say, oh, the contribution to counterterrorism is so enormous, we can't pressure them in other ways--and particularly with Egypt on democratization of Egyptian society.  I think that's a mistake.  I think if you had outside auditors who actually looked into the agency books on what they're really doing bang-for-the-buck on counterterrorism, you might come away with a different view than Langley has.  So I think that's more or less going to move forward.

One could make past critiques of what the Bush administration did and the way it handled itself in Afghanistan, and I think many of those critiques, particularly at Kandahar and Tora Bora, are correct.  But that's, you know, water under the bridge now.  But basically I think it's small-bore counterterrorism in Pakistan and it's large strategic issues promoting democracy.  And I would say that the holy warrior killings of al Qaeda may in fact be now ricocheting against them in the Middle East.  Time will tell, but the slaughter of women and children, particularly in Iraq, I think may be counterproductive.  I wish I could say that more with greater assurance, but I think so.

Also, I would just add, I'm quite astonished that the number of holy wars in Iraq are so few.  I think if you do a historical comparison with Afghanistan, it's not impressive in Afghanistan.  It was on a periphery of the Muslim world, it was not something that really fascinates a lot of Arab fundamentalist organizations.  So I actually am--I think there's a lot of good news on that front.

The most important thing on that still remains two issues.  I mean, the counterterrorism domestically, as bad as it is and as unfair as it is, the visa programs in the United States have stringent standards they've maintained since 9/11 have been effective and, most importantly, the American Muslim community has not bought off, has not been infected with the disease of bin Ladenism if that were to happen and the entire situation were to change.

And I would just quickly end on Hamas.  I mean its victory, I thought, was easily foreseeable.  I also would say that it's necessary, that the notion--and there may be some differences in AEI on this issue--the notion that you are going to exclude a fundamentalist from the political process is, I think, an illusion.  That's not the real Middle East.  I would suggest that you want to bring them in sooner, not later, because the later--if you try to deny them participation, you're only going to continue to radicalize the community.  Now, I think with the Palestinian community, it's going to be the worst-case scenario test, because you do not have a real state.  You also have a national identity which has intertwined terrorism and violence more successfully, more perversely than any other identity in the Middle East.  So this is going to be a very hard, ugly process.

But the notion that Hamas could have been excluded, I think, was naive.  And now you have the chance for evolution.  Again, it is not going to be pretty; evolution often isn't pretty.  As I've said before, you don't get to have Thomas Jefferson without Martin Luther.  And if you go back and look in the history books, that was not a very happy period.  I'm somewhat optimistic that the Muslims will do a slightly better job than the Christians did, but still, it's not going to be happy and pleasant.

And on that note, I'll stop.

MS. PLETKA:  So remember:  Not happy, not pleasant.

Remember when I said we were going to talk for five minutes each?  That wasn't true.

Let me turn to you.  We have about 15 minutes for Q&A.  If I could just ask everybody to wait for the microphone, please to identify yourself, and, unlike us, do be succinct in your question, if you don't mind.

Or don't ask anything, in which case we can wrap up.

Carol?

QUESTION:  Carol Giacomo from Reuters.  And this is to anybody who cares to answer.

Why hasn't the Bush administration taken the decision to support a pro-democracy agenda in Iran?  I mean, Nick Burns, in a speech to SAIS a couple of months ago, sort of indicated that there would be more money put to this kind of effort.  The secretary, even, in an interview with Reuters a couple of days ago, indicated that something was still in the works, although she didn't give any details.

So what's the problem?

MS. PLETKA:  This is a policy that has a future and always will--and never a present, I should add, for those who didn't read into that.  I think Reuel should answer this as well.  He's been talking about this.

But Carol, harken back to the president's speech--I think it was 2003, in Los Angeles in the summer.  He gave a wonderful speech to the Iranian people.  It really was directed toward them.  He said, our relationship henceforth will be with the people of Iran, not with this illegitimate regime.

And nothing happened.  And part of the reason nothing happens is because it's hard.  Part of the reason nothing happens is because it requires the kind of imagination that isn't there.  And part of it is that they're not willing to put the kind of money necessary forward.

But maybe you'd like to talk a little bit about this for a moment.

MR. GERECHT:  Yeah, I think there's a real internal division in the administration.  I mean, there are individuals in the State Department who believe seriously in democracy promotion with Iran, and there are those who don't at all.  Langley, no one does.

And it's also impossible to overstate the decrepitude of Langley to wage covert action now.  It has always had problems with it, but it's a muscle that has completely atrophied.  And everybody in the U.S. government knows that.  So it's a process of starting from scratch.

And also, when you commit yourself to this process, it's going to be--it becomes serious, it becomes real.  And there are going to be some Europeans who aren't going to like it.  I mean, it takes you down a path that is going to cause you anxiety and stress in Washington, D.C. and in certain quarters overseas anxiety and stress, and people want to avoid it.

MR. SCHMITT:  Just to state the obvious, the administration is telling itself internally that if they go down that road they have to be willing to deal with the Iranians in Iraq and Afghanistan, and that's a--you know, whether that's justified or not, that's very much part of their calculation.

QUESTION:  Hi, I'm James Luciere [ph] of Prudential Equity Group.

I agree with Reuel that the Kagan piece in the Post was very good.  It is regime change, stupid.  It does seem that there are a few good military options.  But what could possibly come out of the IAEA talks or the Security Council talks except more talks?  Do we deny student visas, tell the Iranians that the Europeans won't build the petrochemical complexes that they want, freeze assets?  It just doesn't seem that there's any there there.  Am I missing something?  What could, concretely, we do?

MS. PLETKA:  Well, I mean, the obverse of your question is why do anything?  And not doing anything seems to me to be a bad approach, just because our options are fairly limited.  It is worthwhile to see a referral because in fact the rule of law and the rule of treaties is something we're interested in.  We're interested in it having a salutary effect on other countries.  I'd also remind you that we started off the Security Council with Iraq, and look where we are now.  Not everybody might be happy about that, and the Iranians should look at it fairly closely, too, but this is the beginning of a process.

Finally, you know, I do think that we need to look at Iran not just as a proliferation problem, but in the way that Reuel and others have described.  This is a whole problem.  If we are able to prod Iran on one side, it will provide us opportunities on another.  If we are able actually to make demands through the Security Council that they don't abide by, it does force countries into positions that they wouldn't otherwise be in.  Just look at the Indians.  They've made decisions on Iran that they would not have made otherwise.  I think even the Russians have made decisions on the Iranians that they, again, would not have otherwise.  We have an interest in an international nonproliferation regime that works.  And that means that we have an interest in pushing forward to the letter of the law, even if we can't exactly see where the results are going.

Did anyone else want to add anything?

MR. SCHMITT:  Not that I think this would be essentially determinative, but the truth is the Europeans actually could squeeze the Iranians pretty hard if they wanted to.  There's an immense amount of economic activity that, of course, Europeans want to keep up.  But on the other hand, if some of that was curtailed, there would be a lot of dislocation economically for the Iranians that would really hurt.

QUESTION:  I'm Susan Page with USA Today.

You've talked about many parts of the world and I wonder to what degree you think Iraq trumps all of them for President Bush.  Is it possible for him to have a successful 2006 and a successful final three years of his term if the situation in Iraq does not improve?

MR. DONNELLY:  Right.  Iraq is still the elephant in the room and, I think, would be very high on the president's agenda.  The question is, also, whether Iraq over a long term becomes--as I think it obviously will--the metric by which the president is judged by history.  And again, just thinking from a security or a military point of view, the puzzle to me is that the, I think, correct scope of the president's vision is not reflected by a military commitment, which to me is the startling and inexplicable contradiction in the president's Iraq policy.

MR. GERECHT:  Yeah.  Iraq goes to hell, the administration goes with it.

MS. PLETKA:  It is remarkable, though, the way the spotlight has shifted and people are paying less attention to it, the fact that polls show that the public is actually willing to contemplate an attack on Iran notwithstanding--without asking any of the questions that have arisen on Iraq, what would we do afterwards?  Nobody's answered that question.  I can't answer it, either.  But it is remarkable that this has not preoccupied people more.

Do we have any more questions?

Okay.  In which case, we're going to break for about three minutes and we will turn to our economists.

Before you put your coats on or run away, just one second, let me do some in-house advertising.  We've been talking about a lot of different things.  We have a conference in two days, a major conference on Korea.  Chris Hill, the assistant secretary for East Asian and Pacific will be keynoting that.  We have a great national security and economic lineup.  We've got an event on Iran this Friday.  It's very timely.  Senator Brownback's going to be delivering the keynote address.  And I've talked about India desperately, trying to get anybody to pay attention, and we have an event on the 16th on the future of the U.S.-Indian partnership as a walkup to the president's visit there.  Bob Blackwell will keynote that for us.

So thank you all very much, and stick around for our economists.
- - -
Panel II:  Economic Policy

MR. GLASSMAN:  I'm Jim Glassman, a resident fellow at the American Enterprise Institute and host of TCS Daily.com.

President Bush gives his sixth State of the Union address tomorrow night.  In this panel previewing the State of the Union, we will concentrate on economic policy.

The panelists are--this is in random order--Joe Antos, who is the Wilson H. Taylor scholar in health care and retirement policy at AEI and adjunct professor at the University of North Carolina at Chapel Hill School of Public Health; Phil Swagel, who will show up later, who's a resident scholar at AEI and former chief of staff to the President's Council of Economic Advisors; Norm-- There he is.  Good timing, Phil.

Norman J. Ornstein, a resident scholar at AEI and author, with Thomas Mann--or Toe-mas Mahn--

[Laughter.]

MR. GLASSMAN:  --of the forthcoming book on Congress, "The Broken Branch."  And Kevin Hassett, who's the director of economic policy studies at AEI and, in 2000, was John McCain's top economic advisor in his presidential campaign.

Last year, in his fifth State of the Union, President Bush declared America's economy is the fastest growing of any major industrialized nation.  In the past four years, we provided tax relief to every person who pays income taxes, overcame a recession, opened up new markets abroad, prosecuted corporate criminals, raised home ownership to its highest level in history, and in the last year alone the United States has added 2.3 million new jobs.

That's February 2005.  All of this is still pretty much true.  China did grow at nearly 10 percent, but at this point I guess it's only half an industrialized nation.  And in 2005, the United States added 2 million jobs instead of 2.3 million mainly because of big shortfalls in September and October after Hurricane Katrina.  And we, or I as a former New Orleanean, hope that the post-Katrina recovery will be addressed tomorrow night.

Fourth quarter GDP growth was surprisingly just 1.1 percent.  I'm sure Phil Swagel will address that.  But the U.S. still grew at over 3 percent for the year, about twice the growth of Europe and well above Japan.  The stock market gained for the third straight year, though not by much.  Meanwhile, some see signs that the economy is slowing.  Certainly the real estate boom is dying down and there are worries that we face problems with the already legislated tax increases, or reversions as some might call them, at the end of 2008 and then in 2011.

Still, the economy would seem to be a bright spot for the president and one would expect that he will emphasize the success.  The question is whether he will discuss the largely ignored report of the Breaux-Mack Tax Commission and whether he will resurrect Social Security reform.

One economic issue that he will discuss, and I am myself very happy about this because I pay attention to it, is the threat to the U.S. competitive edge in technology.  Several reports have highlighted the decline in the American leadership position.  In March, Richard Freeman of Harvard will be here to discuss an important paper on the threat to U.S. economic leadership.  Freeman writes that "the U.S. share of the world's science and engineering graduates is declining rapidly.  The job market has worsened for young U.S. workers in science and engineering fields relative to many other high-level occupations.  China is on the verge of producing more science and engineering Ph.D.s than the U.S., and already the EU as a whole produces nearly twice as many."  And Freeman considers the off-shoring of IT jobs to India, the growth of high-tech production in China, and multinational R&D facilities in developing countries as harbingers of the U.S.'s diminished comparative advantage in high-tech.

What is to be done?  We'll see what the president says, but clearly there is a role in public policy for the improvement of science education both in secondary school and post-secondary.  Basic research in sciences beyond biology and biochemistry should be augmented--these are my own views; immigration restrictions must be eased; tax policy needs to encourage more R&D; and corporate taxes--and Kevin Hassett's the world's expert on the subject--the U.S. has the highest rates in the developed world--must be lowered.

One of the president's problems in the State of the Union is that the most important economic threats that the U.S. faces--Social Security and Medicare solvency, rising tax rates, and the threat to our comparative advantage in science and technology--all those are longer-term problems, not the sort of subject matter for a speech whose title denotes the here and now.

And now our panelists.  Norm Ornstein, since I didn't tell a joke, I'm sure you will.  We'll start with Norm.

MR. ORNSTEIN:  Actually I have a bad cold, so I may not tell a joke today.  I do want to start with an observation.  When the economy was the fastest-growing of all industrialized nations, Phil Swagel was at the Council of Economic Advisors.  He left, and now growth has declined dramatically.

[Laughter.]

MR. ORNSTEIN:  I don't want to suggest a cause and effect here, but I'll leave that up to you.

I want to set the political context and leave the econometrics to my colleagues.  This is an important address for the president, at least as important as State of the Union addresses go, which are usually not very important at all.  But there are times when we gauge a president--his tone, his confidence, whether he's going to be able to rebound and carry through--by how he handles himself in the State of the Union message.

I'm reminded at least a little bit of the State of the Union message that Bill Clinton gave after the Monica Lewinsky scandal hit and we wondered how he could even get up and give a speech at that point.  And he gave an extraordinary, confident speech and it gave him a boost.

President Bush right now is in the midst of a very severe case of second-term blues.  It may be the avian flu of second-terms blues.  His approval rating is now, average, at about 42 percent.  That's up from its lowest point, but for second-term presidents, that is Richard Nixon territory.  And that is not a territory that presidents want to be in.

He's got upside potential, certainly.  When the presidential election took place, the president was at about 49 or 50 percent.  After starting his presidency at around 52, and then of course soaring after 9/11, staying extraordinarily high before moving into that downward glide path that took him to the point of the election.  We have a very divided electorate, and his upside potential, basically, barring some dramatic event, a crisis that would move him much higher, is right around the 50-52 level.  But you could at least argue that there are about 50 to 52 percent of Americans who want him to do well, who are looking for signs that he's on the rebound, who would prefer to approve of his performance in office rather than disapprove.  Given that, the fact that he's still around 42 after all of the efforts he's made since the election is striking itself.

He faces a Congress that is in disarray, in disarray in a whole host of ways--now, of course, riven by the allegations of scandal and the fear that it will metastasize and basically dominate through the remainder of the year.  All kinds of Republicans who disdained any notions of reform are now born-again reformers scrambling to find new ideas so that they can get ahead of the pack.  Some of them, no doubt, will be crazy ideas and perhaps take it too far.  But we will get into a bidding war on reform. That adds a whole series of new items to the agenda, items that deeply divide members of Congress because it hits them right where they live in their day-to-day activities.

The House, of course, will start out with one of the most bitterly divisive things that could ever happen in a Congress, which is a leadership battle that almost always leaves deep wounds and scars that do not heal for a long period of time.  You have your colleagues taking public stands against you, often saying the harshest of things publicly and privately, and you have a secret ballot vote in which the norm is to lie.  And of course after the votes are totted, a lot of time is spent trying to figure out who betrayed you in the end.  The winner is going to look at all of those who voted against him with a jaundiced eye for a substantial period of time.  The losers will lick their wounds and look for ways to get some measure of revenge.  That's not a way to find a united party as you move into a very difficult legislative year.

And if there is a change, keep in mind that as we enter a moment of agenda-overload, an enormous series of items on the agenda, if there's a change, it's going to take them a substantial period of time to move leaders out of offices, move new leaders into offices, change the staff--all while you're trying to move ahead with your agenda.

If there isn't a change, there will be a continuing frisson of fear that more shoes will drop and they will be back to other sets of problems.

Now, the agenda-overload--and consider one part of it, which is, I would argue, a stark failure of leadership on the agenda right now as they move ahead.  Now including, of course, all of these elements of lobbying reform with what follows, immigration about to come up, a Patriot Act that expires almost as we speak, a continuing set of conflicts over major appropriations bills that were not resolved at the end of the year, a budget reconciliation package and a series of tax matters as yet unresolved, and many more things.

And the House of Representatives is just back today.  They took the month of January off.  Now they will come back to their break-neck pace of Tuesday late afternoon to Thursday morning schedules to deal with this agenda.  It is absolutely astonishing to me that they are so tone deaf to the problems that they face, much less the problems of the country.

The Senate has been sort of back for a short while, although doing not much along the way.  And of course we'll also deal with the Alito nomination right away, with Senate Majority Leader Bill Frist, a lame duck leader, with more leadership potential contests ahead there.  One of the stories in Roll Call this morning is how Trent Lott isn't going to declare his candidacy for a leadership post at the beginning of the next Congress, but he's poised to consider that if and when it comes.

And with, of course, Frist hoping to give the president the great trophy before his State of the Union message of Mr. Alito on the Supreme Court.  That would require not just breaking a filibuster possibility, but they're expecting that they might have cloture vote.  They'll get the 60 votes and then they can move ahead.  The rules of the Senate are such that if you have a cloture motion and it succeeds, you then have 100 hours of debate allowed.  So there are many ways in which Democrats can, without doing very much, keep this from providing that trophy, but it will soak up some time and effort and energy and also cause some difficulties in the relationships in the Senate along the way.

So the president faces all of that.  And as he goes before the joint session of Congress and the American people, he has a series of other challenges, political and substantive and otherwise.

One of them is an issue of whether in this speech he will consciously be a uniter and not a divider, or consciously be a divider and not a uniter. The president in his recent pronouncements, including with Bob Schieffer on the Evening News and Face the Nation and in his interviews leading up to the State of the Union, has said that his greatest disappointment now in five years in Washington is that he's been unable to change the tone.  And he's tried so mightily.  He's been so nice, and he just can't understand it.  This, of course, coming just a few days after Karl Rove gave the great red-meat speech to the troops saying we're going into the 2006 election and it's very clear:  It's going to be the Republicans, who are post-9/11, against the defeatist Democrats willing to cave in and not see any problems out there and willing, of course, to let Osama bin Laden speak to anybody he wants without any surveillance.

That's not easy to reconcile, frankly.  With State of the Union messages, if you've looked at the last several, it's been very interesting to watch.  Presidents put these speeches together with their speechwriters and their teams, and they know what the applause lines are.  And it is a conscious decision about whether you want applause lines that will get 500-plus people up off their fannies applauding, or 200-plus people standing up, with about 200 others sitting, hands on their laps, in stony silence.  The last few State of the Union messages have focused far more on the latter than on the former.  Designed to whip up the base and to draw a stark contrast with the Democrats.  That's something to watch on Tuesday night.  And you'll see very clearly what those lines are and who jumps up and who does not.

Next is something that Jim alluded to:  How much will the president focus on major initiatives?  In running for reelection, George Bush said, "I am not going to be like so many other second-term presidents who are caretakers.  I'm going to be a transformational president.  I am going to recapture the domestic agenda that I lost, that was taken from me, by 9/11."  And of course the themes that he mentioned as he kicked off his campaign, and indeed right after the election, were two.  Two big ones, just as he started his presidency with two big ones that were the focus of his first State of the Union message.  Those were tax cuts, of course, and education, leave no child behind.  These were Social Security and tax reform.

Curiously, during the campaign he almost never mentioned tax reform.  So far as I can tell, there was only once when he got explicit, and that's when he was asked about the idea of a national sales tax and he said something to the effect of that's an interesting idea that deserves further exploration.  Then he kicked off his tax commission after the election, that kicked the can down the road through most of his first year and then issued a report, as Jim suggested, that didn't get very far.

He took much more initiative with Social Security reform, although the new ideas in the campaign were very much the same as the ideas that he'd raised in the 2000 campaign.  And after several months, which included the 60 cities in 60 days where public support for personal or private accounts in Social Security actually dropped a little bit, that idea got pushed to the side.

Will he raise those again?  If not, or even if he does, will he add to them with new ideas.  And it appears certainly that he is going to turn the focus to health care in a significant way, something about which my colleagues, I'm sure, will have things to say.  And it's not surprising, perhaps, that he will do so.

I think he is going to raise health care--my guess is he will bring these up because he wants to show that he's not cowed by either public opposition or congressional indifference or opposition to his major initiatives, that he does not give up, that this is a president who continues to push forward with what he believes in, whatever the odds, and that has been one of his great political strengths.

But he's raising health care at this point, I think, as an issue that has been almost suppressed in the political dialogue for the last few years, somewhat to my surprise--no doubt because these international issues have taken over and crowded them out--because there is clearly a growing level of unhappiness, unease, and discontent in the health care arena, as there is in the pension arena.  It will be curious to me to see if he also raises pensions.

As more and more news stories emerge; as we move to the Enron trials; as we saw, just for one example, a piece by Ben Stein in the New York Times yesterday taking United Airlines to task for the way in which they've allowed their executives to get enriched while the workers and retirees have gotten stiffed on pensions and health care; as we've seen the same thing happen with columns about Delphi, the level of unease among people who are insured, who have jobs, about whether they're going to keep their insurance, whether they will pay much more than they have been paying, whether they'll be pushed off onto part-time or consultant status, whether they will lose the pensions that they believe they have been guaranteed is much higher than it has been before.

The problem of the uninsured, which was a nonstarter in 1994 when there were 37 million uninsured, but a focus on them meant you were telling 215 to 230 million people who were insured this is not about you--you'll pay so that others can get something--now has changed.  With 46 or 47 million uninsured, but with another 50 to 100 million who are very uneasy about where they're going to be, it's a different dynamic.

But how far you can go with a budget problem that Congress finds entirely vexing, with no strong ability to deal with entitlements which can only be restrained in their growth with broad bipartisan support--something about which there is almost none--with defense, as the foreign policy panel suggested, almost certain to increase in cost, with homeland security costs going up, the focus turns yet again to the 15 percent or so of the budget that's discretionary domestic spending and on taxes, to the continuing pressure to deal with the problems of the alternative minimum tax, adding new tax credits or tax breaks on, finding ways to restrain that 15 percent of government--and if the conservative forces in the House take over the leadership, that's going to be their major calling card--while still managing to achieve new initiatives in health care will be difficult.

And finally, to get to the issue of technology, through the last few years we have been cutting basic research, cutting it by hindering DARPA, cutting science education and many of the programs in the National Science Foundation, cutting much of the basic research in health and in other areas, to suddenly turn around and find robust new spending in these areas when you're under pressure in other places is going to be difficult to do.  Matching the rhetoric with the reality, which is the great difficulty always in these speeches, but more so now at this time of very, very difficult political challenges for the president, will make this a particularly interesting speech for those who find any interest whatsoever in State of the Union messages.

Thanks.

MR. GLASSMAN:  Thank you, Norm.  Here's a quick question.  Who's going to win the leadership race in the House, and does it matter?  The "does it matter" part, very brief.

MR. ORNSTEIN:  The "does it matter" part, in terms of forging the perfect unity that Republicans had through much of the first four years in the House, making the House like a house of commons, I'm not sure it matters.  I don't think anybody can do that.  It matters in terms of, perhaps, tone, in the sense of whether there's a strong desire for change.

There's no doubt in my mind that Roy Blunt has a very substantial advantage, but I'd be surprised if he won a first ballot victory.  And then he's going to find it a little difficult to hold on after that.  But the basic answer to that question is nobody has a majority at this point, and we just don't know.  The House Republicans are really in a state of unease and have no strong sense of direction with this right now.

MR. GLASSMAN:  Thank you.

Phil Swagel, why don't you go next and then Joe and then Kevin.

MR. SWAGEL:  Thanks very much.

Well, I'll talk very briefly about the state of the economy and then go through a few of the major policy areas.  Some of them I'm going to skip over very quickly, with the expectation that Joe and Kevin will talk about health and tax policy, of course.

Well, just to note, to follow up with some data, the state of the economy, at least is very strong, notwithstanding Friday's relatively weak GDP data, which I think most of--at least, the Wall Street analysts have come to grips with and feel comfortable with, that the weak growth was essentially a series of one-time factors.  And the data that we have indicating growth for the first part of 2006 are very strong, and we got more strong data this morning on consumer spending.  So we have GDP growth which, you know, I don't think anyone expects we're going to have 4 percent growth going forward, but we'll comfortably cruise around 3.5 percent.

The labor market has strengthened considerably.  Unemployment is down.  In employment growth, you can see that the growth on sort of the latter upside is not as steep as it was in the late '90s, but it's still trending upward at a reasonably fast rate, particularly given the slowdown in immigration.

So I think that's the state of the economy, that overall things look pretty good.

Obviously, the next question, Is everyone gaining?--you know, some places the next data you'd see would be household median income.  Unfortunately, those data only run through March of 2004.  Something that's a little bit more current is the labor share of income.  And you can see that the share of income going to workers is down from a peak of a few years ago.  And this is just that some large part of the gains from the recovery have gone to owners of capital.

And the reason for this, I think, is one of the big questions that we're going to look forward to answering in the next few years in economics.  Some possibilities would be globalization, continued de-unionization, de-industrialization--the change from manufacturing to services, continued change; you know, maybe tax policy.  My guess is that in the short run, that this change, that the gains going to owners of capital instead of to labor, is a short-run phenomenon.  And this graph shows the relationship between productivity and real wages.  This is labor productivity and real wages.  And this is one of the strongest relationships in economics.  And we can see that, over time, when productivity growth is strong, real wage growth is strong as well.  We've had very strong productivity growth the last five years, even stronger than the five years before that, which itself was very strong.  And so I think there's every expectation that real wage growth will pick up and that the share of income going to labor will pick up.  It's a bit of a mystery why it's been so slow, but I think everything we know about economics tells us that it will happen.

But in the meantime, it's a very convenient--it's a great point if you want to talk about how--you know, the sort of two-America story.  This is--the previous graph, this is the two-America story.  And this is why--you know, that story might not be available in a couple of years.

Looking forward, the challenge facing the United States--and some of which we'll see addressed in the State of the Union--is national saving.  You can all see the top, the green line, national investment has remained strong.  We're not in an investment bubble anymore, but it's still quite strong, whereas national saving has plunged.  And of course the difference between those two is our current account balance.  So it's no surprise we have a huge trade deficit.

There's two challenges, to raise public saving and to raise private saving.  I guess I'm sort of similar to Norm in thinking that the short-term situation is really--these are my words, not his--but the short-term situation on the budget is hopeless.  I realize there's a lot of hand-wringing on the deficit this year.  It doesn't seem to be hurting us.  Interest rates still seem low.  You know, people who do wring their hands about the current deficit, on the one hand it's appropriate; on the other hand, I think that takes you to the wrong place.  This is the forest and the trees.  And, you know, just the observations that the Bush tax cuts '01 and '03 are about 2 percentage points of GDP and entitlements are set to rise by 18 percentage points of GDP, so roughly to double over the next 45 to 55 or 65 years, depending on whose estimates you look at.

And so sometimes I think people who worry about, oh, let's repeal or roll back part of the Bush tax cut are missing the forest for the trees.  It's almost--I mean, I understand people worry about the deficit, and obviously a week from today, when we get the budget, we're going to see more and more of that hand-wringing, but I think that there's a sense in which too much of that is counterproductive if it leads people to forget the real long-term fiscal danger.

And obviously, that brings us to Social Security and Medicare.  I guess I have just one observation, and that is it's hard to imagine providing for future health care without some increase in government resources above the 18 percent historical rate over the last 30 or 40 years.  So we're going to have higher taxes in the future to pay for Medicare.  It seems--you know, I don't think next year or the year after, but 30 years from now, I suspect the share of government revenue out of GDP will be higher than 18 percent.

We know that will have adverse consequences on growth.  The CBO put out a nice report last month, December of '05, going through that, the long-term fiscal situation and the effect of taxes on growth.  It would be an awful shame to start in with those adverse effects by raising taxes to cover Social Security, which is a very modest problem.  So that's my view.

Raising private saving, I suspect we could hear some more about this tomorrow night.  Sometimes there's two problems, and I think those are often conflated in the public discussion.  One is policies that will mainly help low-income households, who are right now not saving and facing serious problems when they reach retirement age.  And these are the things like making 401(k)s more automatic, providing a match for low-income households to save.  I think there's probably broad bipartisan support for many of these policies.  I suspect we'll see some version of this go through.

The thing that's important to keep in mind is good policy, it'll help many people, but it is quite distinct from the macro economic problem of the graph I showed before.  You know, even under the most favorable outcome for these policies, the effect on national saving will be very modest.  It could be closer to zero than anything else.  It's worthwhile just to keep in mind it doesn't solve the problem of saving.  And unfortunately, the reality of the U.S. economy is that we want rich people to save more.  I mean, that's how we raise national saving.  And here, tax reform is key, and obviously Kevin is the expert on that.

And then one last note is entitlement reform might also boost personal saving.  And sometimes, if middle- and upper-income households need to save more for retirement, you'd expect that to boost personal saving as well.

Obviously, Joe is the expert on health care.  I'm going to skip over quickly on this.  I have just one observation.  I'll say fewer words than are on the slide.  Obviously, I'm a fan of the policy direction we'll hear tomorrow night.  I worked on it a bit in my previous job.  I suspect in the short run it's going to feel incremental; in the long run, I think it has a potential for a profounder change as a move to individual health care.  And sometimes my first question, my first bullet point, right, we can go in one of two directions--to a single-payer model or to an individual model.  I suspect the country would prefer the latter to the former, but I think we're going to find out over time.

I have a few other observations, but I think I'll skip those for now.

Energy.  I suspect we could solve the U.S. energy problem just by using less of it to heat this room.

[Laughter.]

MR. SWAGEL:  Some of the things we've done--I guess it's probably hotter here with the lights.  We've done a few good things last year with the energy bill--electricity reliability, we're going to build some natural gas terminals, make it easier to get secure natural gas from Trinidad and places like that.  There are some possibilities--hopefully, the president will talk more about essentially getting rid of some of the barriers we have now to building new refineries, to getting rid of the boutique fuels, which reduce the flexibility of the economy.  One day--the third bullet about a gas tax or BTU tax is not a discussion of the level of revenue or tax hikes or tax cuts, it's about the composition of revenues.

And then a few things to avoid, which obviously--possibly the rebuttal to the State of the Union might have more about evil energy companies and the like.

I'll just touch on the first of my bullet points here, which is on regulation.  To me, it's fascinating that every little town or county in some sense still has a hand in regulation of telecommunications and provision of certain technology--television and things like that.  In a sense, why should the Town of Rockville or Montgomery County, where I live, why should they have a say in whether I can buy, you know, certain cable or Internet from this provider or that provider?  You know, one might conjecture that it's--you know, sometimes there's a bit of a rent-seeking motive to--you know, we have TRC as the Rockville channel, so instead of having a channel that I'd like to watch, one of the channels on my TV is devoted to essentially the Rockville Town Council droning on.  So I think that's in some sense an area for future reform.

Financial markets, obviously, is going to be on the agenda.  It might be too detailed for us to hear tonight.

And then finally, I have just a few things to say on international competitiveness.  It's a little of a strange issue for economists.  Economists think of international economic engagement as generally win-win.  So the concept of competitiveness doesn't fit neatly into this view.  Paul Krugman has really nice article from 1985 discussing this, in Foreign Affairs.

Really, the issue is to do things that raise productivity growth or to remove barriers that reduce productivity, and trade barriers, my specialty, is an obvious one.  The idea is competition is difficult, but it's good because it raises productivity.  And then think back to my decades-long chart, we know productivity growth raises wages.

So that leads us to the agenda I have at the bottom.  I want to focus on education, on stability.  You know, I suspect the new fad is going to maintain the sort of economic stability and good policy performance we've seen, and then focus on flexibility.

On trade, we've had some recent good news, avoided tariffs on line pipe steel.  We're going to get rid of them on cement.  We're going to remove the Byrd Amendment, which is hurting American families.  Obviously, soft-wood lumber, our trade dispute with Canada, is the next one.  And I think that's an important one to get rid of just because it so manifestly hurts the poorest of Americans by raising the price of housing and raising the price of apartment rents as well.

The Doha Round, there's a sense in which the problem, I think, is with Europe now, but maybe they're doing us a political favor.  Because if Europe eventually moves, then I think the question is will the U.S. be able to deliver on our own issues with our own agricultural subsidies and changing our own trade rules, the dumping and anti-subsidy.

One way to create political space for further trade liberalization would be to revisit trade adjustment assistance. I suspect there could be bipartisan support for that as well, to really revisit training and education and the portability of TAA benefits.

On China, again, economists generally think that engagement is good, brings us lots of low-cost goods.  It looks like the Chinese are substantially over-paying for our Treasury bonds.  We're in the business of selling Treasury bonds, so it seems good if our customers are paying too much.  Having said that, I do think the Chinese currency really will adjust this year.  We're going to hear more on that issue at AEI later this week from the under secretary of the treasury.  And in some sense, moving away from those issues will allow us to focus on intellectual property and on the foreign policy issues that were discussed last time.

And then the last bullet--I'll skip to the last bullet here and then I have one more slide and I'll end.  I'd like to second what Roger Noriega said.  I think the president and the administration show that we can work with anyone and there's going to be a big upside surprise with Latin America.  Sure, Latin America's turned to the left, but we're going to show we can work with anyone who's pragmatic.

My last slide, education.  One observation is that there's really two systems of education in the U.S.  Obviously in D.C. it's the Friends School versus the rest of the education--that was a joke. But it's really the college.  So the first one, college, versus the rest.  And we have the best colleges, the best higher education in the world.  We have a very large and growing trade surplus in higher education services trade.  One could say that foreigners are outsourcing their education to the U.S.  I'd like to go on the record yet again as favoring continuing in more of this outsourcing.

Really, the issue is high school, primary schools--there's a lot of policy already in place that is dealing with that.  I don't know if it's the right policy.  And again, to advertise AEI, we're going to hear more of that tomorrow with an education event here.

Two last questions.  Pre-kindergarten, it might be useful to reevaluate.  We do a lot of spending at the pre-kindergarten level.  There's a very mixed literature, a large but mixed literature, on whether it's worth it.  And it's really not an issue of less money or more money, it's are we getting value for the money.  Unfortunately, it's a really easy issue to demagogue--you want to take away money from any of the existing programs, it's easy to say you're against children.  I don't think that's the real issue, but we'll see if we can make progress.

And then my last point is, Are math and technology different?

You know, to an economist, the gains from education are largely internalized.  Everyone sees, high school students see, in some instances, the geeks getting right; right?  I mean, everyone knows that geeks get rich, and to me, that's all the incentive people need or should need to go into math and technology.  So that's my point on math and technology.

MR. GLASSMAN:  Thank you, Phil, and by the way, the Rockville Town Council will be the next panel, will be right after we finish.  So stick around.

[Laughter.]

MR. GLASSMAN:  Do you think the president is going to talk about Social Security reform and tax reform?

MR. SWAGEL:  Clearly.  I mean, he's not going to allow the line that he's giving up on Social Security and I think that's great.  He shouldn't.  And certainly Social Security has to be the first step before Medicare.  Tax reform, I don't know.  And maybe Kevin has a better sense.

MR. GLASSMAN:  And just like really quickly, if we have this huge problem with Social Security and Medicare, and if virtually everybody knows that why are interest rates, why are 30-year bond rates so low?

MR. SWAGEL:  Oh, boy, if I knew that, I would--you know, it's hard to understand.  The Fed has a nice study that they did late last year saying that inflows of foreign capital contribute about 150 basis points to lower U.S. interest rates.  So that's probably a large part of it, and the question is why--

MR. GLASSMAN:  They don't know about this Social Security problem.

MR. SWAGEL:  Exactly.  In some sense that's--you know, maybe the way I'd put it is the markets clearly expect us to deal with our long-term fiscal, unsustainable situation.  They don't know how but they expect us to do it because otherwise interest rates would be higher.

MR. GLASSMAN:  Thank you.

Joe Antos.

MR. ANTOS:  You know, so much for efficient markets.  Well, as Norm indicated, the president has no choice but to address health care issues.  Health care is a two trillion dollar industry in this country.  It's growing very rapidly, it always has, and the latest figures say 8 percent growth in recent years.  You'd think that's a pretty robust part of the economy, and in one sense it is.

But as Norm said, people are worried.  There are 45 million people who don't have insurance and there are many more people who don't trust their employers, maybe rightly so.  So they're worried about what will happen to them next.

Health care costs are rising.  That's the downside of that rapid growth, it's really costs, and employers are concerned about it.  Even General Motors has taken a bold move to introduce a $5 copay for drugs to their white collar workers.

Clearly, there are real problems with this sector.  The president has to address some of those real problems but he has a political problem that may be even greater.  So in the Medicare arena, for example, the real problem, as Phil indicated, is the long-term growth of the Medicare problem and what are we going to do about it.

The political problem, more than anything else, is the short-term dissatisfaction with the Medicare drug benefit, the concern that, well, if you read the Washington Post or any of the large newspapers, uncounted millions--I mean, it's hard to know.  Many people are having trouble getting drugs through this program.

The president has to address this issue.  However, he's not addressing poor people with their--I don't think he'll be addressing poor people with their health care problems.

This is something that will eventually be resolved.  The administration keeps saying this and it's true.

But politically, I think the people he's addressing are people like me.  I'm a baby boomer.  I have a mother who's in Medicare.  I'm worried about what will happen to her.

And the question really is can I count on this program for my mother.  I'm more worried about my mother than people I don't know about.

And I think that pretty well characterizes the political problem.  It's the voters, after all, that the president will be speaking to, and the most important voters are the baby boomers, I think, I this regard, because they're worried about their mothers or they're worried about their children.

They may be worried a little bit about themselves as well but we're big, we've got political power, we can take care of ourselves.  Might have to charge the kids.

Okay.  So that's Medicare.  Before the formal remarks, Norm indicated that the president would be taking a victory lap on Medicare.

I'm not sure about that.  Norm had kind a two models of applause at the State of the Union.  He said, well, you could go for 500 plus, or you could go for 200 plus.  In the case of Medicare--

MR. ORNSTEIN:  One hundred plus.

MR. ANTOS:  One hundred plus maybe.  I was thinking fifty plus.

The president has to sell the program again to Republicans as much as he has to sell it to the American people.

What about the other big fear?  The other big fear is costs are rising, I have to pay more and I don't trust my employer.  Those are excellent fears.

Phil indicated that, in essence, there's a choice between a single payer system and consumer-driven health care, and Phil indicated that most people would probably want consumer-driven health care, and he might be right, although with a caveat that of course it can't cost us anything more.

The president will probably not be making that promise but he will be addressing some of the fears associated with our complicated and not so secure health insurance system for people under sixty-five.

He's going to be addressing ownership and portability more than anything else.  He will be emphasizing, once again, health savings accounts.  Hard to say what he will actually propose there.  Some of those ideas are relatively inexpensive but some of them could be pretty costly.

The big idea that we will at least hear the concept of and a week from now we might see some traces of it in the budget, has been attributed to this book.  Our colleagues, John Kogan, Glen Hubbard and Dan Kessler, have a book that addresses a lot of very familiar themes in health policy but one new idea, or at least one big new idea, which is to level the playing field between insurance and out-of-pocket spending in terms of the tax treatment of that kind of money.

The whole idea there is to encourage people to take the money out of their pocket when they go to the doctor, rather than have it funnelled through a third party payer.  Again, the theory is, if you pay for it out of your pocket, you might have some understanding of what it costs and you might begin to ask the question, Is this something that I should be doing?

Should I go to the doctor for him to tell me that I have a cold, Norm, and I can't do anything for you.

I think those are the major themes.  There are other concerns that will I think come up, either in the State of the Union or the budget, but in the end, I think the president has to go back on the offensive in an issue that everybody acknowledges is fundamentally not a Republican issue.

Whether the policies that have been passed are good, bad or indifferent, those who favor them believe that Democrats passed them.  Those who oppose them are certain the Republicans did it, including many Republicans who claim that they didn't vote for it.

MR.     :  I'm not quite clear.  How can health care be a plus for the president  in the State of the Union Address?

MR. GLASSMAN:  Norm?

MR. ORNSTEIN:  I don't think it can be a plus for the president, but he has to address at least the Medicare issue, in the sense of saying, I think two messages.  One is no, we have not forgotten about low-income people and we are working day and night to resolve that problem, and two, you 20 million people who haven't signed up for it yet, it's a really good deal so why don't you do that.

That will be, you know, 150 to 200 applause line, I would say, that last bit.

On people under 65, on insurance, under 65, empathy goes a long way, we'll see what the policies are.

MR. GLASSMAN:  Okay.  Finally, our leader, Kevin Hassett.

MR. HASSETT:  Thanks.  I'm going to, as Norm did, try to finish up briefly with a little bit of context for this State of the Union as Phil and Joe, in particular, covered a lot of the economic ground and I don't want to repeat.

I think that if we were to write Bush's legacy today, suppose that we stopped the economic clock today, that it would be really a difficult legacy to characterize.  That he doesn't have any kind of coherent economic rationale for the actions that he's taken in fiscal policy.

In fact you could argue that President Bush is the most incoherent economic policy maker that we've ever had.

If you go back and look at presidents, they generally have a theme, like you might have a balanced budget kind a guy, or a tax-cutting kind a guy like Reagan, or with Clinton, he was kind of a fiscal responsibility guy, at least after the Republicans took control.

So you could see where they were coming from, at least.  But with Bush, he's had a whole mishmash of policies that don't really fit together in a sensible way, and I would guess that, at times, this is a real problem for him and the White House.  This is something that causes them consternation, keeps them up at nights, and one could characterize as follows, in a really short sentence.

That they've cut taxes aggressively, like Reagan, but when Reagan did that, he cut nondefense spending, actually went down significantly, in double digits, because he recognized that ultimately the government, you know, in present value, has to pay for itself, and so the size of government is what the size of taxes is, it has to be.

And what Bush did is he cut taxes, and then instead of following Reagan and holding the size of government down, he increased the size of government at a rate that's unprecedented.  He outspent Lyndon Johnson's Great Society.

Reagan reduces nondefense discretionary spending in the double digits and under President Bush it's increased now something like 50 percent since he's been in office.

And so he's really set up a house of cards and the important thing about this State of the Union is that it might be the last time that he has a chance to fix anything.

  Maybe next year but I think that's about it, cause then we're coming in right up to whoever's running for president is going to be controlling the front pages of the newspapers and so on.  So it'd be very hard, and I would say unprecedented, for a president in his last year of office to dramatically reshuffle the deck.

And so this is a very important State of the Union for President Bush because it's going to launch whatever domestic agenda that he might have.

But he has a problem, and the problem is that last year Social Security had about the same effect on the president's legislative agenda as Monica Lewinsky.  It not only killed itself but it killed everything else too, and so last year was a year when they, you know, swung for the fences and struck out, and I would guess that there's going to be a temptation to want to play, especially amongst Republicans on the Hill whose necks are at stake in the fall, to look for small victories this year, to make a lot of hubbub about relatively small things and then actually pass them, so that you can go into the fall looking like successful legislators.

And so that's I think an essential conflict that the president faces, and if we look at what big challenges he might address to try to recapture some of his economic momentum, I think Norm's characterization of how many people standing in the hall is actually terrific, because I think it helps us guess where he's sort of going to go and I think it's a good place.

First, there's the long-term stuff that everybody's mentioned.  It's just he tried it last year and it didn't work.  It doesn't look like--and there'll be some tinkering around the edges of Medicare, for sure, and with perhaps with the Kogan-Hubbard-Kessler plan.  But there's not really going to be anything big going after the big entitlements.

And I would guess that what happened with Social Security means that those things are really dead until we have another president.

So what's the other big challenge that our country faces?  And I think that if you look at the literature out there, and again, Jim mentioned that we've got Richard Friedman [ph] coming here in a little more than a month to talk about this.

But there's a lot of new evidence out there, including an extremely important study by the National Academy of Sciences, that suggests that the U.S. is about to have a kind of "sputnik moment" where we wake up and we recognize, well, you know, sure we've got problems with outsourcing jobs, you know, overseas, the manufacturing jobs, the textile jobs, and things like that.  But we're kind a used to that and we grow anyway.

The reason we've grown anyway is that we have a scientific supremacy that perhaps starts at the universities that are, as Phil mentioned, insourcing activity, but it continues to like the best venture capital market, and so on.

We've got, or have had a supremacy in science that is being very aggressively challenged by everybody else out there because they recognize that the reason why the U.S. has been able to stay ahead is that they had a scientific advantage, and they're pushing hard, with very, very, at times, aggressive subsidies by governments to go after it.

And so, for example, this year, it's likely that the U.S. will graduate about 70,000 hard science graduates, engineers, and the same year, China will graduate about 500,000, and the proportion, if you look at the proportion of scientific degrees in the U.S. then--I was actually looking at a list of countries--the top is Finland where it's actually almost 15 percent, but the U.S. it's much less than half that, and we're actually tied with Kyrgyzstan, which, you know, I guess must be a great country, Kyrgyzstan.

But, you know, I think that when you actually look at the development and the tendency, now, to outsource software, and really what used to be white collar things, that's going to be a challenge that everybody recognizes as true.

And so what I think is probably going to happen is that we need to play--you know, he needs to play small ball, and so he's going to, I think, go after scientific supremacy and maybe try to create a kind of "sputnik moment" in the speech and talk about, well, we've been the leader, we can still be the leader but we've got to change the way we do things.

But notice that if he does that, that what it means is that it's not really going to address the fundamental conflicts, or internal conflicts, logically, with his economic policy.

So he might, you know, it really looks like he might be a fellow that leaves with a very incoherent legacy, a person who cut taxes but pushed big government without recognizing that you can't do both at the same time forever.

And so with that, I look forward now to turning it over to Jim and your questions.

MR. GLASSMAN:  Thank you.

Questions from the floor?  Wait for the microphone and tell us who you are.

MR. SLOAN:  Stuart Sloan, American Jewish Committee.  I have a question about energy.  The president has been hinting a lot, lately, that he's going to talk about energy and reducing oil imports in the State of the Union message.

Do you think he will?  What will he say, and do you think it can be an issue that he can coopt over the Democrats and get some mileage out of it?

MR. HASSETT:  I think there's a problem--Phil knows a lot about this.  I think there's a fundamental problem with energy policy, which is that the optimal policy is to have no policy, that you just let the high prices tell people what to do, and so you can say that--like say you want to say, okay, we want the U.S. to be energy independent.

Well, you know, the Hassett family, we're energy independent too.  I wish we had, you know, our own energy assets, but if you don't have them, you've got to buy them from somebody else, just like we have to buy molybnium from Africa or something.

So the notion that we should be energy independent, it's just not an achievable goal, and lip service can be paid to energy policy, but in the end it's high prices that you need to allow things to adjust, and the only really prudent, economically sensible policy, aside from maybe allowing more exploration, which would certainly help a little bit, I know that there's some hurdles to exploration that are politically contentious.

But it's not going to solve the problem.  The only thing you could do would be to really jack up carbon and BTU taxes, if you really wanted the economy to sort of efficiently move towards being more energy efficient.

And I don't see him proposing a big increase in a BTU tax, and so there's got to be a fundamental conflict there, that you kind a want to have self-sufficiency but you recognize that it's kind of a stupid goal, given where we are.

MR.    :  I'd just say a few words, you know, agree with everything.  I suspect we're going to hear more about hydrogen and the related issue of fusion, and, you know, as a lot of people have commented, that's promising, but it's very far off, and again, to me, it goes to what's the role of the government and I would see that as really focusing on basic research.

There's other things like tar sands, and, you know, things that are essentially becoming commercialized, are commercial now, and to me, that's just like what Kevin said--high prices move us into tar sands and things like that.  We don't need government intervention there.

MR.    :  Just a note.  Politically, obviously the president addresses this, and the same reason that he addresses the health care issue--I feel your pain--and we're not just sitting here sucking our thumb as we've got policies and we're going to move forward.

He's got to do something like that.  But as long as the pain is there, it's not going to do very much, and on the energy front, no doubt he will make yet another pitch for drilling in Anwar and that'll be 200 people standing up and applauding, but it doesn't move the public at this point.

And as long as there are high gasoline prices, it's a political problem for him.  But I think, getting back to our previous panel a well, that if we end up with more uncertainties of supply and the real political problem is not price, the real problem is whatever the price, you can't get it.

Anybody who was around in the early 1970's, and remembers the disruption to our daily lives when you topped off your tank, you waited in line for an hour, you waited to see if somebody was going to cut in front of others and then the guns would be pulled out.

All of that is one of the worst things that could happen, politically, to a president.

So I think this issue has great political impact potential, and most of it is not particularly good for the party in power.

MR. GLASSMAN:  We manag