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End Game

End Game

Economic data over the past weeks, punctuated by last week's dismal employment reports, confirm the diminishing impact of the stimulus efforts orchestrated by the Obama Administration and the Federal Reserve. In what must be a huge disappointment to Keynesian enthusiasts, the record doses of both monetary and fiscal narcotics did not produce the desired results. In fact, the size and scope of the “recovery” of the past two years was weaker than would have been expected in a typical business cycle recovery without any stimulus whatsoever. Indeed our current recovery is the weakest on record, despite the biggest jolt of government stimulus ever administered. 

But despite the gathering gloom Austan Goolsbee, the Chairman of the President's Council of Economic Advisors, argued over the weekend that the economy is on the right track and that the recent salvo of horrific economic reports were not significant. The poor numbers, he said, resulted from external factors like the Japanese earthquake and the downgrade of European sovereign debt. I don't know if he really expects anyone to buy his story, but admitting you have a problem is the first step toward recovery.
In a sign that Mr. Goolsbee may have been getting increasingly uncomfortable with his job of economic propagandist, he abruptly resigned this week. He will be returning to academia where I'm sure he is hoping to avoid blame for the coming economic train wreck. 
Although I have made these comparisons before, the parallel between drug addiction and the reliance on economic stimulus is just too strong to ignore. And as with drug addition, an economy builds up a tolerance. Each time the government successively stimulates with printed money or deficit spending, ever larger doses are needed to achieve the same result. Lest we forget, coming into the Crash of 2008, the economy had been on the receiving end of years of over stimulus. President Bush and Alan Greenspan never fully weaned the economy of their shock treatments that followed the crash and the shock of September 11th. 
This time around, the stimulus-fueled recovery is so mild that the economy is already relapsing into recession before the Fed has even begun to tighten. This puts Bernanke in a very difficult position. He either follows through on his loudly trumpeted plans to end quantitative easing this summer, or abandon those plans in favor of more stimulus. Both choices are unappealing. 
Given the current economic weakness will any additional deterioration, that will surely result from a withdrawal of stimulus, be politically viable? Real estate prices are already at new lows and unemployment refuses to diminish even with the punch bowl fully spiked. What would happen if it contained only cranberry juice?
To avoid these short-term consequences, the Fed can instead admit that the recovery cannot survive unaided. Bernanke would have to reverse his previously optimistic outlook, and launch QE3 even as QE2 barely pulls into port.  But why would anyone believe that the “growth” that results from QE3 will be any more durable and robust than what resulted from QE1 and QE2?  Economists like the stimulus-loving Paul Krugman will surely argue that that the stimulus has been too small (like $5,000 in annual deficit spending per American is a trifling sum). But to believe that the next dose will do the trick borders on sheer insanity. When QE3 comes and goes (which I'm sure it will) the Fed will face the same choice that it faces today, yet with even greater consequences. It's a self-perpetuating cycle that ends in disaster.  
Just like a Hollywood movie, each QE sequel gets progressively more ridiculous (my apologies to Johnny Depp). The government needs to admit its mistakes and write a completely different script. This time the story line must allow for a real restructuring. Real estate prices must fall further, and many financial institutions holding bad mortgages must fail. This means investors, creditors, and depositors will lose money. Labor and capital must be re-allocated away from services into goods production. That means jobs must be lost in government, retail sales, finance, health care, and education; and jobs must be created in technology, manufacturing, textiles, mining, energy, and agriculture. This guarantees major short-term pain. But breaking an addiction is not easy. Those who say it is are living in a fool's paradise.   
This transition does not require any positive action from government. All it needs to do is simply get out of the way. That does not mean there is nothing the government can do to help the process. It can remove as many regulations and taxes as possible that inhibit market forces from working their magic. But this requires a completely different mindset among our elected officials. They will need the courage and knowledge to level with the American people, and do what is in our nation's economic interests, not simply what is in their own political interest.
Foreign governments too must get out of the way and let market forces work. Their support for the U.S. dollar must end. If they do, U.S. consumer prices and interest rates will rise, as they must. If the Fed tries to combat the effects of a falling dollar with more QE the dollar will fall even further and consumer prices will rise even higher. The cycle will either end with the Fed as the only buyer of all U.S. dollar denominated debt (wiping out the value of the dollar) or a Fed engineered rate hike that brings the cycle to an end. Both scenarios are catastrophic, but the latter at least offers the possibility of redemption.
The same experts who did not see the 2008 financial crisis coming also fail to see the world in these stark terms. And while it gives me no pleasure to forecast the demise of the U.S. economy, I hope that at least the reputations of these “experts” will sink with it. 

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