This is a rush transcript from "The Journal Editorial Report," December 30, 2006.

PAUL GIGOT, FOX HOST: This week on the "Journal Editorial Report," the big stories of 2006 that will continue to shape your world in the New Year.

With conventional wisdom calling the war a failure, is there a way forward in Iraq? And can President Bush find it?

Plus, Hillary Clinton and John McCain may be the frontrunners now, but who will lead the pack as we an approach the primaries?

And will the go-go economy of 2006 go bust under the policies of the 110th Congress?

But first, these headlines.

(NEWSBREAK)

GIGOT: Welcome to the "Journal Editorial Report." I'm Paul Gigot.

From war in the Middle East to a political sea change here at home, it was a remarkable year. So for our final show of 2006, we thought we would look at how the big events of this year are going to shape the news of 2007 and beyond.

We'll begin with the biggest story of 2006 — Iraq.

Joining the panel this week, "Wall Street Journal" Columnist and Deputy Editor Dan Henninger, OpinionJournal.com Editor James Taranto, Editorial Board Member Steve Moore and our taste and culture guru Naomi Schaefer Riley.

Dan, this week the president said victory is still attainable in Iraq, juxtaposed against the Iraq Study Group report saying it isn't. Is there a way forward the president can find?

DAN HENNINGER, WSJ COLUMNIST AND DEPUTY EDITOR: Well, let's put it this way, Paul. I think a way forward is a lot better than a way backward. Which is to say, the way backward, suggesting something like a pullout, would be simply catastrophic for the region.

Now, I think, in retrospect, the Iraq Study Group served one useful purpose. It was a wake-up call to everyone. I think the Iraq government was treading water. I think the Bush administration and the White House was also treading water on Iraq. This is kind of like a big stone into the water. Everyone has had to pull back.

I think that what we're going to see now is — you know President Talabani of Iraq denounced the report. You will see more movement among the political factions inside Iraq. When Sadr withdrew from the government, Muqtada al-Sadr...

GIGOT: The radical cleric.

HENNINGER: The radical cleric — pulled out of the government, those that remained started to form a new governing coalition that excluded him. And just this past week, he decided he would come back into the government. So I think we are having more movement now than we have seen in long time.

GIGOT: James, one thing that struck me, as you look at the president give his speeches and he had that listening tour, went to the State Department, the Pentagon and listened, had his generals in to talk about — to give him options for Iraq. He isn't projecting a lot of confidence that he knows the way forward in Iraq. Do you get the same sense?

JAMES TARANTO, OPENIONJOURNAL.COM EDITOR: I do. It has been a rough year beginning, I guess, in February, with the attack on the mosque. That kind of set off all the sectarian violence.

But at the same time, I think it is important that we take the long view. A lot of very good things happened in 2005. We had a series of elections. We had other reverberations in the region, with the Seder Revolution in Lebanon and so forth. And at that point, it was easy to be triumphal and to say everything is going our way.

It is tempting now just to be defeatist and say this is all a disaster. But history has a way of working these things out. And I think when people start to saying things like this was the biggest strategic blunder in American history and Bush is the worst president ever, you know, that's kind of crazy talk.

GIGOT: There were a lot of people saying that after certain battles of the World War II and the Civil War and then certainly in Vietnam as well.

The paradox may be that the president needs to actually do more to move forward in Iraq. That actually, by being more aggressive, more troops, more emphatic, more assertive militarily, he may be able to have more political support than if he backs down.

And I am thinking of John McCain and Joe Lieberman and others, who are supportive of the war, but are wary because we are not doing enough to win. What do you think of that point?

HENNINGER: Well, I think that's right. I mean, General Abizaid pulled the U.S. troops out of the streets of Iraq. Now, I think they are talking about putting more troops in or embedding U.S. troops with the Iraqi troops.

There seems to be some agreement now that what the Iraq government needs to function is security. They need to be protected. They need a buffer between them and these radical groups.

And I suspect that, if the American troops now go in there and take a more pro — I mean, they have to do that. The alternative is doing nothing, which is what we have been doing.

GIGOT: Not just clear, but clear and hold, and then hold with Americans and Iraqis being able to provide secure zones for Iraqi civilians to feel safer?

HENNINGER: Hold and secure those Sunni — in the Sunni neighborhoods.

GIGOT: That's right.

James, talk about the American politics of all this because we've seen Gordon Smith, the Senator from Oregon, up for election in 2008, give a very pained speech on the Senate floor, backing away from his support of the war. Are we likely to see, in 2007, the Republican support for this war fracture down the middle?

TARANTO: We may. On the other hand, I think that the Democrats are going to have to be more responsible than they were in 2006. Toward the middle of the year, we had this move toward the Murtha position, which is just get the heck out of there. Go to Okinawa.

GIGOT: Go to Okinawa. The threat.

TARANTO: Yes. And it seemed like that was gaining ground in the Democratic Party. Well, one of the things the Iraq Study Group said, and the one which they got exactly right is, as Dan said, pulling out would be catastrophic.

The idea that we can just pull out and everything will be fine, we'll return to the status quo and everything will be all right, that's just escapism. And the Democrats can't afford to be escapists now that they're in a position of responsibility.

GIGOT: How does Hillary Clinton, the frontrunner for the Democratic nomination, walk this line between the people who want to pull out now and the people who say — well, she voted for the war so she — and who don't want a defeat...?

NAOMI SCHAEFER RILEY, WSJ EDITOR: But now, she regrets it.

GIGOT: She said that?

RILEY: Yes, she said she regrets it. So now, I mean, it is John Kerry all over again. And she's still got two more years to change her position five more times, so.

TARANTO: Well, John Kerry didn't say he regretted it until he had lost in the 2004. And I think the one thing that really helps Mrs. Clinton is the fact that Senator Lieberman, from Connecticut, beat the anti-war Democratic nominee quite handily, showing that the Democratic victory was not just about Iraq.

GIGOT: Steve, we don't have a lot of time, but John McCain?

STEVE MOORE, WSJ EDITORIAL BOARD MEMBER: I was just going to mention him.

GIGOT: Is his war position going to hurt him going into the primaries? He has been supportive all along.

MOORE: Well, it could be. But I think in terms of talking about the politics of the war, keep an eye on how John McCain does. He is the frontrunner right now. He has been steadfast in his support of the war. If he continues to have a strong number with the Republicans, I think that will behold other Republicans to stick with the program.

GIGOT: All right.

RILEY: I think a lot of Americans are asking themselves what would have happened if John McCain had been elected the first time.

GIGOT: All right, Naomi.

When we come back, looking ahead to the 110th Congress with Democrats at the helm. What's likely to get done? And heaven forbid, is a tax increase on the horizon?

Plus, from the London terror plot to the bombings in Mumbai, the events of 2006 reminded us that we're still fighting a War on Terror. Can progress be made in the New Year?

(COMMERCIAL BREAK)

GIGOT: Big changes coming to Washington in the New Year with Democrats poised to take control of both Houses of Congress for the first time in more than a decade.

James, the Nancy Pelosi — Speaker Pelosi era beckons. Can Democrats in Congress work with President Bush on agenda — some agenda or are we going to get gridlock?

TARANTO: Please, gridlock.

(LAUGHTER)

Actually, there are some issues on which I think they may be able to work together. On immigration, for example, the president's view, which is more — let more immigrants in, is closer to the view of the Democrats than it is to his own party. So he may have an easier time getting through.

On the other hand, remember the last time we had a Republican president and a Democratic Congress. It was President Bush's father. And we got this big tax increase.

Now, the son has been very good about not raising taxes. But, of course, this time he doesn't have to worry about reelection. So I'm afraid that he may cut some sort of deal that will be very costly to all of us.

MOORE: But I've been predicting, James, that with this Pelosi Congress and Democrats looking ahead to 2008, that they will govern as a very conservative party. I am predicting that actually spending in the next two years will go up a lot less than it has in the last five years under Republicans.

GIGOT: So minimum wage, that's a conservative idea, Steve?

MOORE: Well, but no, I mean...

(CROSSTALK AND LAUGHTER)

GIGOT: Price controls on drugs, that's a conservative idea?

(CROSSTALK AND LAUGHTER)

MOORE: Keep that discussion going.

(CROSSTALK AND LAUGHTER)

HENNINGER: Most presidents, under these circumstances, concede to the other party.

MOORE: Right.

HENNINGER: Richard Nixon produced the Environmental Protection Act and the Clean Air Act. And Bill Clinton produced welfare reform.

MOORE: That's a good point.

HENNINGER: So what do you think George W. Bush is likely to produce?

MOORE: Well, hopefully, not a Social Security deal. Because just in the last few days, President Bush has said, well, maybe I will put all things on the table. That includes tax increases.

And I think that, if the Republicans go along with a tax increase- Social Security deal, it will be the ruination of the party. It will do a lot of harm to the economy by the way, too, by raising that payroll tax cap. That's has huge marginal rate increase.

GIGOT: Why would they do that, Steve? What is the motivation?

MOORE: Well, you know they want to...

GIGOT: Is it legacy? Is that it?

MOORE: Well, it's a legacy issue for President Bush. He's always wanted to fix this Social Security problem. But it is like the Andrews Air Force base that we had in 1990, that big budget deal that destroyed Bush Senior's presidency.

GIGOT: All right, let's move to presidential politics, Naomi. John McCain, clearly the front runner. I know John Fund, our colleague, was saying this week that something like 70 percent of George Bush's big donors have moved to McCain. He's got the momentum. Is he stoppable?

RILEY: Well, it doesn't look that way at this point. And I think it is interesting that he is one of a very few candidates who's coming out with — republican candidates who's come out with a very clear position on what to do in Iraq.

And I think people are really looking for leadership on that issue right now. I think Romney has been a little wishy-washy. And I wonder whether that's really going to be his ticket to the top.

MOORE: What's really strange about this field, you have got three frontrunners on the Republican side — Romney, McCain and Giuliani. And a lot of conservatives say, where is the conservative in the field? And I think there's a lot of conservatives who are feeling, I don't feel attached to any of these guys.

HENNINGER: But, you know, there is it a truism now in politics now, Steve, which is that organization wins. And if organization wins, McCain wins. And if organization wins, Hillary wins. All of the other contenders basically are running with platoons right now. They've got to hope...

MOORE: Ideology matters.

HENNINGER: Ideology matters. And also these people can blow themselves up. But, by and large, they've got the big movement (ph).

GIGOT: Well, let's talk about Hillary Clinton, James. She is clearly the frontrunner. I think even more so than John McCain is on the Republican side. She's got a kind of massed army of people, consultants and idea people and advisors, waiting to go. And, of course, she has Bill pushing her ahead. Can anybody stop her?

TARANTO: I am not sure I see how. We have had, toward the end of this year, this talk of Barack Obama, who will have served in the Senate all of four years and will be 47 years old at the time of the presidential election.

I think Obama looks like a very strong candidate for 2012 or 2016. But Hillary just looks, to me, like the prohibitive favorite on the Democratic side.

On the Republican side, McCain, the biggest thing he has running for him may be that he's the guys who's next in line. He finished second in 2000. The Republicans, except 1964, almost always pick the guy who's next in line.

MOORE: Well, he has something else going for him too. His line, over the next two years is, I am the man who can beat Hillary Clinton. And to a lot of Republican conservative voters, that's a very powerful message.

GIGOT: Well, that fear of defeat with Hillary is really driving a lot of Democrats to at least look at other candidates. Can Al Gore come up on the field? He can actually say, well, look, I won the first time.

RILEY: I just think people have Al Gore fatigue.

GIGOT: I do.

(LAUGHTER)

RILEY: It is just hard to imagine that, after seeing him go around the country with an inconvenient truth and these other things, that people really want to listen to any more. And I just think they have seen too much of him, that's all.

GIGOT: All right, you are all on record. McCain vs. Hillary. We're going to check a year from now.

All right, we'll be back after this short break.

Still to come, the most underreported story of 2006. Find out what it is and how the 110th Congress could affect it in 2007, when the "Journal Editorial Report" continues.

(COMMERCIAL BREAK)

GIGOT: It was the most underreported story of 2006 — the resilience of the American economy. With Democrats in control of Congress, what are the biggest threats to continued prosperity in 2007?

Steve, it's the greatest story never told, as our friend Larry Kudlow likes to refer to the economy. Housing and auto's weakness at the end of this year, could that tip us into a recession next year?

MOORE: What was it? About two years ago, we termed the phrase the Rodney Dangerfield expansion. And every since — what we meant by that is it gets no respect, this expansion. And it keeps gaining steam. And so the answer to your question is, no, I don't see this economy slowing down much at all. The housing slow down has hurt a little bit.

But one of the great other untold stories on the economy is what's going to happen with — what's happened with wages this year. As you know, the only complaint the Left has had about the economy left has been wages not rising. But guess what? This year, wages are rising. We're going to see about a two percent real gain in household income. That's a big deal.

GIGOT: The jobless rate at 4.5 percent.

MOORE: Seven — we just passed the seven-million job mark. One other statistic — 62 months now of straight economic growth. That ain't all bad.

GIGOT: So what are the big threats, if any, to the economy in 2007? Policy mistakes? Are we talking about perhaps trade protectionism, possible tax increases? What are the threats?

HENNINGER: I think — it looks like trade protectionism is fading a little bit. The Democrats participated just in the lame duck session in putting through a couple of freer-trade measures.

But I think the big risk is a tax increase. If they start talking about raising taxes, you know. That is the biggest underreported story. And it has — it cuts in the capital gains tax. And it has contributed so much to the growth of this economy.

GIGOT: Now, those are locked in until 2010, that is the Bush tax cuts of 2003?

MOORE: But don't forget, if they do the payroll tax increase, that reverses a lot of the marginal income tax rate cuts that Bush put into effect. So it would be erasing a lot of the gains that we had on tax policy.

GIGOT: And that's what some Democrats want if they're going to do a deal.

MOORE: That's right. So raising the cap.

TARANTO: Raising the cap to $150,000 would be a tax increase of more than $6,000 on somebody making that amount of money. It is a huge increase on the most productive members of society.

GIGOT: All right, James. The war on terror is still very with us as we learned in Mumbai and the attacks that didn't happen, but almost did, on airliners headed our way from London. Is this the year, 2007, that radical Islam goes back on the offensive in a big way, in your view?

TARANTO: Well, I don't know when it was ever not on the offensive. The thing that worries me the most about terrorism is that there will be another attack like September 11 of that — of similar scale, on the American soil. Because I think, if there is, you know, all bets are off as to how the American political system will react.

What I fear is that we will end up — we kind of reacted to 9/11 by saying let's be very careful, let's not violate anyone's civil liberties. I am afraid we will go too far in the other direction, and civil liberties will go out the window.

GIGOT: Radical Islam had a couple of very big successes in 2006. You could argue that the war in Lebanon was a victory for Hezbollah, Iran's proxies. Clearly, we're weaker in Iraq now than we were at the start of the year.

If history is any guide, Dan, that sends a message to al-Qaeda and the Islamic radicals that we can be had. As Bernard Lewis says, they only respect — they only step back and don't attack us when they really fear us.

HENNINGER: That's right. We've had the interior minister in Britain saying they have 30 active plot investigations going on over there. I mean, so this threat is up and running.

One thing to watch is whether the Democrats do follow through and hold hearings, intelligence hearings, on the Patriot Act, on the warrantless wiretaps, and try to peel back those programs. It seems to me that, if they do, they are simply opening the door for the terrorists to slide through and act.

RILEY: Well, you realize just how bold the Islamists have gotten this year, I think, with the foiled attacks on the British airliners. Because you had all these people after 9/11 saying, oh, that horse has already left the barn. Essentially, they wouldn't try another airline. Twenty planes?

I mean, this is — they've really — they have a lot of confidence. And I think you just need to be worried that they have the right assessment of their strength. And we have the wrong assessment.

GIGOT: Let me ask you about another debate that took place this year, and that's Pope Benedict vs. Islam. There was a controversy about some remarks he made about the history of Islam. But the controversy toned down a bit after his trip to Turkey. But that debate isn't over, is it? That's...

RILEY: It is not over at all. The pope really represents two things here. He is talking about the vacuum that has been created in Europe because it's become so secular. They don't have moral guide posts. They can't say why polygamy is wrong, why forcing everybody not to wear a veil is wrong. They don't have the guide posts anymore.

And then, the pope is saying, look, what's filling that vacuum is radical Islam. It's filling it demographically because these people — the Muslims — the radical Muslims who are coming to Europe are — have much higher birth rates than Europeans. And pretty soon, that's going to be the major idea that's taking over Europe.

GIGOT: He's saying Western Civilization has to speak up and defend itself.

RILEY: Absolutely.

GIGOT: Thank you very much, Naomi.

We have to take one more break. When we return, our panel picks the stories of 2006 they think will have the greatest impact in the New Year.

(COMMERCIAL BREAK)

GIGOT: Finally tonight, our panel takes a look back at some other big events of 2006 that will continue to resonate in 2007 and beyond.

First to you, Dan.

HENNINGER: Well, one of the biggest stories was Warren Buffet saying he that he was going to give $30 billion of his wealth to Bill and Melinda Gates to run the Gates Foundation.

Now, this is big for a couple reasons. There is an enormous amount of baby boomer wealth that's going to go into philanthropy in comings years. And philanthropy can theoretically do good.

The thing about the Gates Foundation and this $30 billion is they have the wherewithal here to create a new model for philanthropy. And I would say it has two points, one accountability. They should measure what works and stop doing what doesn't work. The second thing is give the money away in your lifetime, as I think they are going to do, so that your heirs don't debauch your life savings.

(LAUGHTER)

GIGOT: I think the second point is really crucial. Thanks, Dan.

James?

TARANTO: Paul, at the beginning of the year, Justice Sam Alito joined the Supreme Court, the new Roberts court, or as we call it the Kennedy Court, because the protean Justice Kennedy so often casts these split-the- difference deciding votes.

I think it is worth looking back and remembering how we ended up with Justice Kennedy on the court. He was not President Reagan's first choice. He came in after the Senate, which in the midterm-election in the second term of a Republican presidency had just gone to the Democrats, rejected Robert Bork.

Well, here we have the same situation again. So I think this is a very opportune year for Justice John Paul Stevens, a liberal Republican nominee, who turns 87 in April, to announce his retirement.

GIGOT: A President Ford nominee.

TARANTO: Indeed.

GIGOT: All right, James.

Steve?

MOORE: America and New York City have to be the financial capital of the world. Unfortunately, in this past year, we've been losing that strategic competitive edge. More and more companies are listing and doing their IPOs, not in New York City, but in Hong Kong and London. This is one of the big business stories that a lot in the media didn't cover.

The good news end of this story is that I believe, in 2007, there will be changes to some of these financial regulations, like Sarbanes-Oxley that have sent these companies off-shore, bringing them back by fixing Sarbanes- Oxley laws.

GIGOT: Wait a minute. Barney Frank heading the Finance Service (ph) Committee are going to do this? And do you...?

MOORE: Yes, Barney Frank and Nancy Pelosi want to fix this. It's something Republicans should have done many years ago, but now it's going to get done.

GIGOT: All right.

Naomi?

RILEY: Well, I think one of the big stories of this year has been the split in the Anglican Church. This debate started in 2003 with the elevation of a gay bishop in New Hampshire, Jean Robinson.

And essentially, what's happened recently is that you've had several parishes that have decided, look, we don't belong as part of this church anymore. And the Anglican Church here is really reflecting just about every mainline Protestant denomination in the country.

And I think, in 2007, you're going to see gay marriage is going to remain a very hot topic both politically for all these presidential candidates, and socially. It is really a rift that we haven't seen the likes of since the Civil War.

GIGOT: All right.

James, I just want to follow up on that Supreme Court choice. Do you think the president will nominate another Alito or Roberts if he gets an opening? Or does he bow to the Democrats?

TARANTO: Well, rumor has it he's looking at Gonzalez, the attorney general, which I think would make nobody happy.

(LAUGHTER)

GIGOT: So, no. All right.

That's it for this week's edition of the "Journal Editorial Report."

Thanks to Dan Henninger, James Taranto, Steve Moore and Naomi Riley.

I'm Paul Gigot. On behalf of everyone here at the "Journal Editorial Report," Happy New Year to you and yours.

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