Since 2008, economic policies throughout the rich world have boiled down to one word: stimulus. Interest rates in most countries have been held down well below the level of inflation, while spending programs have pushed national budgets far out of balance. As in Europe calls rise for further doses of “fiscal stimulus” in spite of that continent’s precarious budget position, while in the United States both fiscal and monetary stimulus is widely canvassed, the global economy languishes. It must surely now be becoming clear: as with most pernicious drugs, repeated usage of stimulus is lessening the ”stimulative” effect while exacerbating the adverse long-term side-effects. As this recession drags on into its fifth year, it is becoming one of diminishing marginal returns.

From the various semi-controlled experiments that have been conducted around the world in the last five years, the efficacy of fiscal and monetary stimulus can be assessed. Public spending itself almost always has a multiplier of less than 1; in other words, when the effect of borrowing the money is factored in, it is generally moderately economically damaging, albeit possibly with a lag. There are exceptions to this, but they are fairly scarce. If as in Germany after World War II, public spending is used to rebuild damaged infrastructure, it may be devoted to projects of sufficient economic return as to “pay for itself.”

If a financial shock such as that of 2008 has damaged the banking system sufficiently as to increase the cost of borrowing for the private sector above its normal levels, then public spending on projects with even a modest positive economic return may also be economically beneficial. This does not however justify the Obama “stimulus” of 2009, for two reasons. First, much of it was used for uneconomic subsidies to featherbedded unions, for investments in economically foolish green energy projects and for other uses where the potential return was either negative or far below those in the private sector.

Second, and crucially, the markets turned around in early March 2009, fully two months before the Obama stimulus moneys began to be spent; hence by the time the money was disbursed the banking system was functioning normally. By grossly increasing the volume of public debt issued, the “stimulus” simply steepened the yield curve, enabling the banks to play silly “gapping” games of borrowing short-term and investing in Treasury and housing agency bonds, thereby artificially depriving small business of finance, since the banks couldn’t be bothered to lend to it. Stimulus might have slowed the economic decline if applied in late 2008; by the late spring of 2009 it could have no beneficial effect. Moreover, much of the stimulus actually applied consisted of items that were hard to remove in subsequent year; the permanent increase in public spending has caused further damage because of its effect on debt levels.

In Britain and southern Europe, the public spending “stimulus” had an even more pernicious effect; it strained the capacity of the local capital markets and put in doubt the credibility of the state credit. In Britain this solved by a Weimar-like policy of selling almost all new government debt to the central bank, thus solving the funding problem at the expense of producing an inflation problem. In the EU, this solution was not generally available; hence the extraordinary difficulties of southern European governments, which have had a depressing effect throughout the EU far in excess of any short-term benefit brought by fiscal stimulus.

Monetary stimulus was rendered less effective because in most countries real interest rates had been excessively low since 2002, with U.S. money supply growing too fast since early 1995. Liquidity needed to be injected into the system after the banking crash of 2008. However, as Walter Bagehot remarked in his 1873 “Lombard Street,” it should have been done at penally high rates, not at the ultra-low rates favored by Ben Bernanke, Mervyn King and most other central bankers.
Monetary policy was successful in preventing the recession after 2008 turning into a repeat of 1929-33; by March 2009 the banks were already out of danger and liquidity was returning to the system. At that point interest rates should have been raised to more normal levels, of perhaps 3-4% on the Federal Funds rate. That would have forced the banks to resume lending to small business, since they would no longer have been able to make risk-free profits by “gapping” between short-term and long-term rates. At the same time, the recovery in U.S. savings rates which we briefly saw after the 2008 crash would have strengthened, limiting the deterioration in the balance of payments that has de-capitalized the U.S. economy and made U.S. workers uncompetitive against emerging markets. Unemployment would have declined at the brisk rate of 1982-84, instead of the painfully slow rate of the last three years.

After two rounds of quantitative easing and a year of “Operation Twist” purchases of long-term bonds, monetary policy’s efficacy in producing even brief stimulus is fading. Notably, last Wednesday, after the Fed announced another $267 billion of resources thrown into the monetary stimulus pit, the stock market as measured by the S&P 500 index closed down on the day, while long-term Treasury bond yields closed up. If Bernanke’s billions cannot produce a market bounce that lasts even two hours, the curtain in the Emerald City has finally been drawn away and the feeble magician has been shown up as the charlatan he is.

Similarly in Europe, the two 3-year loans to the European banking system by the European Central Bank, totaling over $1 trillion, produced remarkably little effect for that amount of money. Spanish and Italian banks bought their local government bonds, locking in a substantial profit, but by June the Spanish banks required a 100 billion euro bailout, while Italian and Spanish borrowing costs were hovering around record levels. As for Britain, monetary stimulus there has brought only inflation and the impoverishment of the nation’s savers, faced with real returns of as low as minus 5% on their money.

At this point, neither monetary nor fiscal stimulus is likely to have any significant further positive effect. Francois Hollande’s attempt at further fiscal stimulus will almost certainly land France in the same boat as Spain and Italy, fighting desperately to finance the governments borrowing program, at ever higher rates. While this can be regarded as proper retribution for French socialist moral superiority over the last 30 years, it will make the full break-up of the eurozone inevitable. The added market turmoil that this will produce will make borrowing very expensive in real terms for all southern European countries, including France – which in turn will cause major recession in those countries. That’s the irony of the eurozone crisis – one a country has lost the confidence of the capital markets, its interest rates rise far enough to make borrowing costly for its industry and recession thus inevitable. Only by leaving the euro, undergoing the pain of devaluation, and undergoing an export-led recovery can southern Europe recover.

As for the United States, the safe haven status of the dollar may allow monetary and fiscal authorities to double down of stimulus, certainly if President Obama is re-elected with stronger Democrat representation in Congress. At last Paul Krugman’s dream policy, of perhaps $2 trillion in wasteful public spending financed by $2 trillion of “quantitative easing” Fed purchases of Treasury bonds will be tried once and for all. The result should be spectacular – spectacularly awful, that is. The dollar will collapse, as will U.S. credit, and U.S. unemployment will be prevented from rising to Greek levels only by reducing its inhabitants’ living standards to those of China.

In an ideal world, this would produce a return to a Gold Standard, combined with a balanced budget amendment and an effective line-item veto. In the world we inhabit, that is most unlikely – quacks, charlatans and populists will ensure that voices of economic sanity are entirely drowned out. After all, Paul Krugman has received an economics Nobel and Ludwig von Mises never did. (And make no mistake about it, if Nobels were voted on by the public, perhaps in a reality show “Celebrity Economist” the results would be even worse than they are.

There is an alternative, and one can o9nly hope it will eventually be tried. Interest rates need to be raised to the 4-5% level, above the level of inflation, while public spending needs to be reduced and tax loopholes (housing, charitable contributions) need to be closed, to reduce the Federal budget deficit to manageable levels. The rise in interest rates will cause bankruptcies in the U.S. banking system, not least that of the Fed, which will suffer huge losses on its massive “Operation Twist” portfolio of long-term low-yield Treasuries. For a year, as in 1982 in the United States or 1981 in Britain, it will appear that the policy has failed, and massive wailings will go up to reverse it. Then economic growth will resume, on the basis of high savings, tight money and balanced international trade – the only true foundation for economic success.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)