We've officially been in a recession since December 2007. If we accept the questionable basis on which that determination was made, the current recession has now lasted 18 months. Since the average recession in the last seven decades has been 11 months , it's clear that we are long overdue for a recovery.

The administration and the Federal Reserve have recently been trying to talk up the economy (after previously talking it down to make the case for the Obama stimulus plan). They've been alluding to "green shoots" in the economy . President Obama has essentially claimed that the worst has passed, that we've stepped away from the brink. And a group of economists is predicting the economy will rebound in the second half of this year --which has been the official prediction since at least January.

Yet Chrysler and GM have gone bankrupt and have essentially been nationalized. The same could be said for Citigroup and AIG, along with any other banks that are eventually forced to take stress test money from the government. Despite President Obama's $787 billion stimulus package, unemployment continues to climb with nearly 600,000 new unemployment claims every week. Treasury Secretary Geithner's second bank rescue plan was unveiled to a warm reception in March (after the first attempt tanked), but nearly three months later it doesn't seem anything in his plan has actually been executed. The Federal Reserve is printing money like Zimbabwe, with all the dangers inherent in that approach to dealing with the problem. And despite the Federal Reserve's money-printing with the supposed intent of driving mortgage rates down to stimulate the economy, Treasury bond and mortgage rates are stubbornly heading up in likely response to massive government borrowing. And although the run-up in oil prices is being portrayed as an optimistic reaction to the supposedly-improving economic outlook, that same run-up could simply be due to a devaluing dollar--and could work against a young recovery. The Federal Reserve is revising its predictions to reflect a more gloomy prediction, not a more optimistic one. And despite increasing personal income, Americans are spending less money --something that doesn't bode well for a decrease in unemployment in the near future.

Meanwhile, the Federal Reserve is trying to figure out what to make of last weeks shocking movements in the bond market. Those movements drove bond yields up which took mortgage rates right along with them. The Federal Reserve is wondering whether this is a result of an increasingly optimistic economic outlook or whether it's an expression of worry over the massive--and growing--federal deficit and the possibility that the value of the dollar will fall as a result of so much newly printed money. In other words, the movement in bond yields and mortgage rates could be an indication of an improving economic outlook or a frightfully bad economic outlook.

But given the market fundamentals described above, what exactly is the rational argument that the economy is poised to recover? The only things that seems to support that argument are that we seem to be a run-up in oil prices, a possibly over-exuberant stock market, and the proclamations of government officials (though the Federal Reserve officially expresses doubt). In fact, how can the Federal Reserve really have any doubt? If it recently adjusted its economic outlook to be more gloomy, why would it seriously consider the movement in interest rates to be an indication of something good?

And today Treasury Secretary Geithner got on a plane to China to tell our largest creditor that their dollar assets are safe. That's the second time we've reassured China of that this year. If an economic recovery is really right around the corner is it really necessary to go to such an effort to convince our largest creditor of the strength of our economy?

A Problem With Fundamentals

The stock market has clearly been demonstrating "irrational exuberance" for the last few months. In the face of an almost constant barrage of bad news, the indexes have increased approximately 30% since their lows in March. In the face of the bad bank plan that really offered nothing new, markets rallied. In the three months after the federal government announced plans to further dilute shareholder value in Citigroup, the share price has rallied 50%--and didn't even blink when stress tests indicated that it might need to raise another $35 billion in capital. And in the face of a GM bankruptcy which is looking more and more like an Amtrak money pit , the stock market rallied another 200+ points. Clearly the stock market is not something we'd want to bet to be a reliable indicator of the economy right now.

The price of oil has been defying some logic as well. As recently as two weeks ago it was clearly stated that the fundamentals of oil were terrible: There was more supply than demand. . Yet in the subsequent two weeks the price of oil has continued to rise. Granted it's the beginning of the summer driving season. But the fact that there is significant oversupply in a contracting economy wouldn't seem to justify increasing oil prices.

Given that it would seem that both the stock market and oil prices are behaving illogically, all we really have left is the proclamations of government officials saying that a recovery is expected in the second half of 2009.

But it is curious that we would be expecting an economic turnaround when unemployment numbers continue to rise past 9% .

It's curious that we would be expecting an economic turnaround when in April people spent less and saved more, two things that are not particularly conducive to a recovery.

It's curious that we would be expecting an economic turnaround when consumers are apparently focusing not on more spending but on paying down their existing debt. Again, this is not something that stimulates a recovery.

And it's curious that we would expect an economic turnaround when home prices are still falling. After all, collapsing home prices was the original trigger for the financial crisis.

Hope Meets Reality

So if it would seem at least reasonably unlikely that a recovery is right around the corner, what can we make of rising interest rates and oil prices?

Both of these phenomenon are explained perfectly if we conclude they are a logical response to the increased federal deficit putting upward pressure on interest rates, and to the Federal Reserve devaluing the dollar with more printed money which causes a rise in commodity prices... such as oil.

If interest rates are already being pressured by the beginning of the massive Obama deficits, we're in trouble. Obama has promised trillions in deficits over the next few years and the Treasury has so far only borrowed about $700 billion of that since Obama took office. Not to mention the Federal Reserve has been printing money to try to reduce interest rates. So if the government has only borrowed $700 billion so far and interest rates are already starting to spike in spite of the Federal Reserve trying to push rates down, we're most likely looking at much higher interest rates as the government borrows trillions more.

And if the dollar is already being devalued by the Federal Reserve's printing of money such that the price oil has doubled in the last four months despite a contracting economy and oversupply, that's worrisome. Especially considering some experts are now suggesting that the Federal Reserve should print trillions more. Is it any surprise that Treasury Secretary Geithner is in China trying to reassure them that their dollar-based assets won't lose value?

In short, if the economy isn't about to recover then all the numbers we see are extremely bad news. And if that's the case then everything Obama and the Federal Reserve are doing will exacerbate the problems.

Stuck In Policy Limbo

Obama's stimulus package and proposed trillion-dollar budget deficits require the government to borrow money. But there isn't enough money in the world. That means we're going to be looking at higher and higher interest rates as potential lenders demand more return for their limited amount of money.

Even with higher interest rates motivating more people to loan money to the U.S. Government, there still isn't enough money available. That's why the Federal Reserve has been printing money, and observers are speculating the Fed may need to print a trillion more. This inevitably will devalue the dollar. We are, in fact, seeing that as the dollar today fell to its lowest level of the year. And just as the dollar is losing ground we're seeing a parallel increase in the price of oil which, also today, reached a seven-month high.

And now the Federal Reserve is between a rock and a very, very hard place.

If the Federal Reserve doesn't print more money then the market will move in to set interest rates. And those interest rates will be higher. This will lead to higher borrowing costs for the Federal Government which leaves less money available to spend on the priorities of government. It also means interest rates for consumers will be higher. That will hammer the still-struggling housing sector and make it far more expensive for businesses to try to stage a private-sector recovery. In short, if the Federal Reserve doesn't print more money interest rates will go up, the housing industry will suffer further losses, and the prospect for a private sector recovery are diminished.

If the Federal Reserve does print more money to try to keep interest rates low then the dollar will lose even more value as we print worthless dollars. That will cause commodities such as oil to go up. It will mean Americans will pay more for oil and for products we purchase from China and other countries. That's inflation. And as inflation increases, interest rates must increase even more because no-one intentionally loans money for less than the rate of inflation. In short, if the Federal Reserve prints money the dollar will lose value, commodity prices will increase which is inflation, and interest rates will increase which will cause the same negative impact on the housing industry and the business sector. Further, a devalued dollar will cause more international creditors to stop loaning us money which will cause the Federal Reserve to print even more to make up the difference... a vicious cylce.

It would seem that either way we should be expecting inflation and higher interest rates. But by refusing to print money we can at least preserve the value of the dollar and hopefully maintain it as the international reserve currency.

The only real solution to avoid inflation and higher interest rates is for President Obama to reject the very policies he has been advocating. He must adopt fiscal conservatism now.

Update 6/3/2009: Two days after writing this article, the following similar conclusion was reached and printed in the UK:



The Fed is in a Catch 22. If it buys more Treasuries to push yields lower, it will stoke inflation fears and investors will demand yet higher yields. If it does nothing, and yields continue to rise, then the housing market will take a hit, dragging the rest of the economy down with it again.

There is one solution for governments on both sides of the Atlantic. They can come clean with their electorates and admit current levels of public spending are not affordable.



People around the world are waking up to reality.

If Obama were to freeze--and even possibly reduce--government spending then it wouldn't be necessary for the federal government to borrow money. That would cause bond prices to go up and bond yields (rates) to go down. That would allow other interest rates in the economy, including mortgage rates, to go down naturally. Not because the Federal Reserve was trying to force them down but because that'd be the natural tendency in a free market where not as much money was being borrowed.

Since the Federal Reserve would no longer have to print money to fund the government's deficit spending, the dollar would remain strong. Oil prices wouldn't rise nearly as much. Countries would no longer be interested in looking for an alternative reserve currency. We could avoid or minimize inflation.

The Problem With Liberal Economic Policy

Unfortunately, Obama's spending plans are based on Keynesian theory. This theory suggests that all of this spending and money-printing is going to somehow stimulate us into a recovery despite the mounting evidence to the contrary.

The problem with Keynesian theory can be summed up in one of Keynes' responses to the criticism of his theory as unsustainable. He said, "Long run is a misleading guide to current affairs. In the long run we are all dead." In other words, "Why worry about the future effects of our policies when we're all dead in the long run?"

Yet we have politicians in the White House and in Congress, and policymakers at the Federal Reserve, that subscribe to this admittedly short-sighted approach. And, unfortunately for all of us, "the long run" effects of their policies seem to be having an impact on the markets after only about five months.

I believe the effects of the liberal economic policies unfolding before us will be:

1. Higher interest rates.
   
2. More downward pressure on housing prices.
   
3. A stunted recovery in the private sector.
   
4. Less international interest in U.S. Government debt.
   
5. And if we continue to print money we'll see a devaluation of the dollar, higher commodity/oil prices, decreased foreign investment, increased inflation, and more international interest in moving away from the dollar.

I suspect we'll see a pretty significant correction in the stock markets if/when it concludes that the run-up in oil prices and interest rates aren't an indication of a recovery but rather an indication of fiscal mismanagement by the government. We may also see the price of oil drop if the stock market correction happens soon; but it's also possible the increasingly devalued dollar won't permit the price of oil to drop--which could lead to a period of stagflation.

Update 6/3/2009: Two days after writing this article the price of oil started to drop due to "unexpected increase in supply." It remains to be seen whether this is just a temporary drop or if it reflects the beginning of the longer slide that I predicted above.

We're in the middle of an economic experiment. If anything good comes of it it will be the final realization that Keynesian theory doesn't work. Any theory or policy that defies free market forces is as sure to fail as a sand levee holding back the raging sea. It's simply inevitable.

In the end the only economically sustainable policy is that of fiscal conservatism. But the current administration might have to crash our economy into the brick wall of reality before it accepts that that reality actually exists.