The $150 billion Bush stimulus plan failed. The $700 billion TARP program failed. The $200 billion package to nationalise Fannie Mae and Freddie Mac has not worked. The $42 billion to the Detroit automaker trio doesn't seem to be working. Bear Stearns, AIG, Citigroup and trillions to the new guarantee schemes of FDIC….all totaling to at least $10 trillion to date, and probably a whole lot more by the time the madness ends.

At every step, gullible US citizens were promised that these steps would prop up the housing sector, restore confidence in markets, alleviate the credit crunch and ensure a return to the good old days of borrowing and spending. But the results of all these actions are pretty much there in the public domain and it has been an unmitigated disaster.

So the question: why will the new $787 billion stimulus be any different?

It most certainly will not be. In fact, every step taken above is tantamount to throwing gasoline to douse a raging fire.

The Recession - correcting the malinvestments

A recession is a free market solution to correct the excesses built into an economy during a cheap credit-induced boom and to achieve a rebalance amongst the different sectors of the economy. Therefore, a recession is necessary to clear the malinvestments and to ensure that the future growth starts on a firm foundation.

In the case of the US, there have been tremendous excesses over the last couple of decades with consumers deep in debt and excessive capital flowing towards the housing sector at the expense of other sectors. So what the market is trying to do through the current recession is to prevent credit from flowing to an already indebted consumer and to prevent a resurgence of the bubble sectors.

Therefore, it ought to be recognised that the credit crunch faced by consumers is a legitimate market reaction to account for their inability to repay existing debt; the only solution then is for the consumers to work, under-consume and pay down their debt. Any distant flow of credit to consumers has to be based on their productive capacity and ability/willingness to save.
Similarly, there has been a tremendous excess capacity built into the housing sector due to the artificially low interest rates under Greenspan. These steps were incidentally taken to prevent a recession after the NASDAQ bubble burst and 9/11. While this prevented an immediate recession, the underlying imbalances only got greater in the ensuing period. The solution yet again, is to let the housing prices collapse so that credit is diverted away from housing to more productive sectors of the economy rather than try to re-inflate a bubble sector.

Throwing money at either of these problems is counterproductive. New president Barack Obama needs to embrace the recession as the only solution to the underlying problems. As explained, lower interest rates to ease borrowing and tax credit to home buyers will only make the problems worse.

Printing the road to serfdom

Thus the very idea of a stimulus package is faulty; it is not because the package is too small (as American economist and columnist Paul Krugman has argued and suggested that the stimulus should be to the tune of $2.4 trillion) or because the components of the package are incorrect (as almost the entire Republican Party has suggested). The very idea of the stimulus package is a disaster and the best that the US Government could do is to make itself a smaller burden on the productive sectors of the economy.

To understand why I am saying this, it useful to start from the Krugman suggestion i.e. why not a $2.4 trillion, or for that matter, why not $10 trillion stimulus?

To answer this, the key is to identify as to where Obama is going to get the money from. There are only three sources of funds: tax, borrowing or printing. Given the economic downturn, increasing the tax rates is not politically possible or even if Obama manages that, it is not going to result in increased revenues. Borrowing to fund this exercise is also quite unlikely to be successful as most Central Banks seem to be coming to grips with the con game they have been tricked into. So the only option in front of Obama would be create this money out of thin air or print it.

But it should be obvious that printing only leads to a redistribution of purchasing power in favour of the new recipients and so it increases the percentage of government's contribution to the economy at the expense of the private sector. These are exactly the reasons that caused the Great Depression during the thirties and Obama is pretty much following the footsteps of Roosevelt. At a time of capital constraints, it is best that the capital resources are diverted towards the most productive sectors i.e. private enterprises, rather than the least productive sector i.e. Government.

But isn't spending on the Infrastructure a good thing? Sure, a whole lot better than spending that money in Iraq or Afghanistan. But given that capital is the constraint, who should determine if it is better utilised for building factories or for building roads and bridges? Given the crumbling infrastructure, they sure need to be repaired, but the moot question is, "Can USA afford it." These capital allocation decisions are best made in the marketplace and not in Washington. If Central planning had worked, USSR would still be a single block.

How about Tax cuts? Sure, if it is accompanied by spending cuts. Cutting taxes and then printing the difference probably makes the situation worse as inflation tends to hurt the lower income groups much more. So tax cuts ought to be accompanied by meaningful reduction in government expenditures if it is to make a difference. In this scenario, while Obama might deliver a tax cut, he probably would end up printing a whole lot more and so this would actually worsen the situation.

The Greater Depression

History is going to mark this $787 billion plan as the definitive step that pushed the US towards the Greater Depression. Without doubt, Bush along with Greenspan and later Bernanke, laid the foundation for the event by creating the huge imbalances. But this surely is the moment in history that is going to determine whether it will be a short, but severe, recession or a prolonged depression. This was exactly the choice in front of Hoover/Roosevelt in the thirties and they made the interventionist choice that pushed the recession into a depression.

At least back then, the then Treasury Secretary Mellon gave the right advice i.e. "liquidate stocks, liquidate real-estate", though Hoover, under political compulsions, refused to listen to him. Today both Paulson, and then Geitner, have recommended massively interventionist solutions which have never worked in history and will not this time as well.

For the past few months, all the inflation that has been created as a reaction to the crisis has not manifested itself in commodity prices due to a preference for liquidity (or what could technically be defined as a drop in Money Velocity). When we move over from this stage to a period where people begin to chase real assets, that is when the crisis really hits the fan. And when that happens, the bond bubble is going to burst and the entity that is going to need a bailout is going to be the US Government.