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Optimism for new year masks deeper troubles

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The U.S. stock market enters 2011 in a jolly mood. In the past four months it has leaped 20 percent, to heights last enjoyed when Lehman Brothers was a going concern. Investors are likely to cheer a second consecutive year of double-digit returns.

What happened? In part it is simply a case of the underlying American economy turning out to be stronger than pessimists imagined: consumer spending, business investment and job creation are all up lately. But policymakers have also done their bit. In November the Fed began a second round of "quantitative easing"--buying bonds to push down long-term interest rates. And in December President Obama and the Republicans agreed to extend President George W. Bush's tax cuts through 2012 and to pump a further $300 billion into the economy through a payroll-tax cut and other measures.

Put these things together, and the American economy could grow by nearly 4 percent in 2011. But share prices are meant to be based on more than just the next 12 months' earnings, and the medium term is as treacherous as ever; perhaps more so.

Start by noting that the recovery is subdued by historical standards. This is not because of high interest rates or frail business confidence, the sorts of things that a well-honed stimulus might quickly cure. Rather, households and banks are working off the excess debts of a reckless decade. Monetary and fiscal easing should make this less painful, but the deleveraging still has years to go.

Next, the new tax deal has made the United States' long-term fiscal problems even more intractable. Optimists hope that the expiration of the Bush tax cuts in 2012 will allow a grand bargain to be agreed before then: The lower tax rates could be kept in exchange for a plan to stabilize the federal debt. A good idea, but both Obama and the Republicans are hellbent on fighting the next presidential election over the tax cuts. Neither side has much incentive to fix the deal before then.

Real bipartisan budgeting must involve far more painful things --increases in taxes and cuts in entitlements. The politics of cutting health care and pensions is getting worse. In 2011 the first baby boomers retire and the number of elderly voters will only grow. The Republicans claim they are ready to reform Social Security and the tax system. Obama would be wise to call their bluff by presenting a plan for both in his budget. But don't bet on it.

Wall Street may be right about the economy in 2011. But the U.S. government's inability to sort out its finances in a credible way should unsettle investors everywhere.

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