Research finds more evidence for the efficacy of monetary as opposed to fiscal policy in ending recessions. And the studies on fiscal stimulus have shown more impact from tax cuts than from spending increases.

We also do not know whether the positive G.D.P. growth resulted partially or mainly from natural equilibrating mechanisms, rather than from monetary or fiscal policy. Much discussion of the recession presumes it will end only because government comes to the rescue.

In fact, the U.S. economy recovered from significant recessions before 1914, when monetary and fiscal policy had not even been invented. Economies can and do recover on their own, and intervention might make things worse by generating uncertainty and distorting the economy's allocation of resources.

A further caveat is that two elements of the fiscal stimulus — cash-for-clunkers and the $8,000 tax credit for first-time home buyers — probably shifted significant activity from the fourth quarter and beyond to the third quarter because consumers knew these provisions would expire soon. Thus the stimulus plausibly shifted the timing of economic activity without necessarily improving the long-term path.

The case for additional stimulus is weak. If further stimulus occurs, it should focus on changes in policy that make sense independent of the recession. This means reductions in tax rates rather than increases in expenditure. Repeal of the corporate income tax would be ideal.

The "Greenspan doctrine" on monetary policy says that the Fed should not attempt to check asset price surges ahead of time but just manage the aftermath if they turn out to be bubbles and eventually burst. Such bubbles are difficult to detect before they actually burst, and a consistent policy intended to check presumed bubbles would reduce the economy's long-term growth potential. The job of regulating asset prices rests with market participants whose interests motivate self-regulation against undue market-risk exposures.

But in a speech last week, Fed governor Don Kohn said that "central banks are being encouraged to 'lean against the wind' in the face of asset price bubbles. We need to be honest about our very limited ability to assess the 'fundamental value' of an asset or to predict its price. Research should help to identify risks and inform decisions about the costs and benefits from a possible regulatory or monetary policy decision attempting to deal with a potential asset price bubble."

This suggests a re-thinking of the Greenspan doctrine within the Fed. The recession that began in 2007 has been enormously costly in terms of output and job losses. It is not surprising that Fed economists are examining whether monetary policy could prevent such episodes in the future instead of simply "mopping up" after the fact.

It's well known that the Fed successfully averted economic meltdowns after Wall Street swooned on several occasions: the stock market crash of 1987, its intervention to resolve the LTCM failure during 1998 and the even sharper bursting of the stock price bubble in 2001.

However, memories of those "successful" Fed interventions may have spurred even larger subsequent surges in asset prices because of their moral hazard effects on investor attitudes toward risk. Although other factors such as ratings errors and improper SEC regulations were important contributing factors, the recent financial collapse would not have been as severe without prior Fed-induced moral hazard among investors. So should the Fed now be formally vested with the responsibility of containing asset price bubbles pre-emptively and regulating financial firms?

Economists have long lamented problems in assessing whether asset price increases constitute bubbles and in predicting the timing of asset price bubble bursts. Setting capital standards and ancillary regulatory frameworks for financial institutions is more art than science. Given economists' poor predictive ability in evaluating macroeconomic risks and setting appropriate capital buffers for financial institutions, the Fed is bound to eventually (and spectacularly) fail at preventing asset price bubble bursts followed by severe financial disruptions. Then calls for congressional investigations and oversight on monetary policy would threaten the Fed's independence.

Indeed, making the Fed a financial super regulator would only provide formal sanction to policies that have increased moral hazard effects in the first place. Once the current recession is over and the Fed has withdrawn its extra-normal initiatives to restore credit markets, the correct policy approach may be to do the exact opposite — to signal that there will be no super regulator for financial institutions and to formally prohibit the Fed from engaging in bailouts of non-bank financial firms. Such a formal stance by Congress on financial regulatory policy is the best bet for developing mechanisms for sustained and effective self-regulation by market participants.

Fed officials are probably well aware of the dangers of accepting responsibility for setting financial regulatory standards and using monetary policy to prick asset price bubbles. The dangers are in setting anti-bubble policies that are so draconian they reduce the economy's long-term growth potential and eventually fail to protect financial institutions and the economy from a large macroeconomic shock. Such failures could permanently compromise the Fed's independence in monetary policymaking.

Although Fed analysts will doubtless continue research on the causes of asset price bubbles, they would be foolish to accept formal responsibilities for pre-emptively containing asset price surges and becoming financial super-regulators.

This view is a pipe dream. Most new regulation will do nothing to limit crises because markets will innovate around it. Worse, some regulation being considered by Congress will guarantee bigger and more frequent crises.

Government-Induced Moral Hazard Caused the Crisis

The Financial Crisis of 2008 did not occur because of insufficient or ill-designed regulation. Rather, it resulted from two misguided government policies.

The first was the attempt to promote homeownership. Numerous policies have pursued this goal for decades, and over time they have focused mainly on homeownership for low-income households. These policies encouraged mortgage lending to borrowers with shaky credit characteristics, such as limited income or assets, and on terms that defied common sense, such as zero down payment.

The pressure to expand risky credit was especially problematic because of the second misguided policy, the long-standing practice of bailing out failures from private risk-taking. This practice meant that financial markets expected the government to cushion any losses from a crash in mortgage debt. Thus, the historical tendency to bail out creditors created an enormous moral hazard.

One crucial component of this moral hazard was the now infamous "Greenspan put," the Fed's practice under Chairman Alan Greenspan of lowering interest rates in response to financial disruptions that might otherwise cause a crash in asset prices. In the early to mid-2000s, in particular, the Fed made a conscious decision not to burst the housing bubble and instead to "fix things" if a crash occurred.

It was inevitable, however, that a crash would ensue; the expansion of mortgage credit made sense only so long as housing prices kept increasing, and at some point this had to stop. Once it did, the market had no option but to unwind the positions built on untenable assumptions about housing prices. Thus government pressure to take risk, combined with implicit insurance for this risk, were the crucial causes of the bubble and the crash. Inadequate financial regulation played no significant role.

New Regulation Must Avoid Moral Hazard

If government-induced moral hazard caused the crisis, then new regulation should avoid creating or exacerbating this perverse incentive. Yet two components of proposed regulation will increase, rather than decrease, the chances for moral hazard.

One proposed change in regulation would give the Federal Reserve increased power to supervise financial institutions, especially bank holding companies such as Citigroup or Bank of America. This approach is a triumph of hope over experience. Why should an expanded Fed role be beneficial when the Fed erred so badly in the previous instance?

Defenders of an expanded Fed role will claim that, in the lead up to the crisis, the Fed did not have explicit powers to supervise and monitor non-bank financial institutions, and that such powers could have avoided the crisis.

Yet during the years before the crisis, the Fed had more than ample power to recognize the unprecedented level of risk that was building in the economy and to issue stern warnings, whether or not it had explicit regulatory authority. In fact, far from cautioning the market to behave, the Fed promoted the notion that it could solve any problems that might result from a bursting of the housing bubble.

Regulators are fallible. Alan Greenspan, once thought to be the Maestro, got it fabulously wrong. Ben Bernanke, regardless of the merit's of his stewardship, will not be Fed chairman forever. Centralized and expanded power to make things better is also centralized and expanded power to make things worse. In particular, any mistakes made by a powerful, centralized authority have a magnified impact because they distort the behavior of the entire market.

Just as problematic as granting the Fed additional powers is the proposal to allow the FDIC to resolve bank holding companies using taxpayer funds. Under the proposed arrangement, the FDIC rather than bankruptcy courts would be responsible for bank holding companies, and the FDIC would be authorized to make loans to failed institutions, to purchase their debts and other assets, to assume or guarantee their obligations, and to acquire equity interests. The funds would be borrowed from Treasury.

This means that FDIC resolution of bank holding companies would put taxpayer skin in the game, a radical departure from standard bankruptcy and an approach that mimics the actions of the U.S. Treasury under TARP. Thus, the new approach would institutionalize TARP.

The result will be that under the proposed system, bank holding companies would forever more regard themselves as explicitly, not just implicitly, backstopped by the full faith and credit of the U.S. Treasury. That is moral hazard in the extreme, and it will create an unprecedented incentive for excessive risk-taking by these institutions.

The Bankruptcy Approach

The only way to limit financial panics is to eliminate government-induced moral hazard, and that means letting failed institutions fail. Whether resolution is carried out by the FDIC or a bankruptcy court is not the crucial question; rather, it is whether that resolution process forces all the losses on the institution's stakeholders rather than bailing them out with taxpayer funds.

The standard objection to allowing failures is that some financial institutions are allegedly so large or interconnected that their failure causes a breakdown of the credit mechanism, thereby harming the whole economy rather than just transmitting losses that have already occurred. According to this view, letting Lehman Brothers fail was a crucial mistake that initiated the meltdown, and bailing out other financial institutions was a necessary evil to prevent even further chaos. Nothing could be further from the truth.

Rather than being a cause, Lehman's failure was merely the signal that time had come for the U.S. economy to pay the price for all the distortions caused by the misguided policies toward housing and risk. Given those distortions, a massive unwinding and restructuring was necessary to make the economy healthy again.

This restructuring required lower residential investment, declines in stock and housing prices, and shrinkage of the financial sector. All of this implied a recession, even without any impact of financial institution failures on the credit mechanism, and the recession meant that lending would contract, even without a credit crunch.

The bailout itself, moreover, caused much of the financial market turmoil. The announcement that the Treasury was considering a bailout scared markets and froze credit because bankers did not want to realize their losses if government was going to bail them out. The bailout introduced uncertainty because no one knew what the bailout meant. The bailout did little to make balance sheets transparent, yet the market's inability to determine who was solvent was a key reason for the credit freeze.

Thus letting Lehman fail was the right decision; bailing out Bear Stearns, Fannie, and Freddie in advance of Lehman, and the rest of Wall Street afterwards, were the mistakes. For all its warts, bankruptcy rather than bailout is the right way to resolve non-bank financial institutions. Any regulation that formalizes bailouts creates an enormous moral hazard and a black hole for taxpayer funds.

The Future

To limit future financial crises, policy must first avoid the distortions inherent in the attempt to expand homeownership. This means eliminating the Federal Housing Administration, the Federal Home Loan Banks, Fannie Mae, Freddie Mac, the Community Reinvestment Act, the deductibility of mortgage interest, the homestead exclusion in the personal bankruptcy code, the tax-favored treatment of capital gains on housing, the HOPE for Homeowners Act, the Emergency Economic Stabilization Act (the bailout bill), and the Homeowners Affordability and Stability Plan. None of this is sensible policy.

In addition, policy must end its proclivity to bail out private risk-taking. This second task is difficult, since it requires policymakers to "tie their own hands." Specific changes in policies and institutions can nevertheless support this goal. The first is avoiding new regulation that makes bailouts more likely. A second is repealing all existing financial regulation, since this would signal markets that they, and only they, can truly protect themselves from risk.

The third and perhaps most important way to reduce moral hazard is to eliminate the Federal Reserve. As long as the Fed exists, it will regard itself as, and be regarded as, the economic insurer of last resort. In a world with perfect information, appropriately humble central bankers, and an absence of political influence on monetary policy, such a protector might enhance the economy's performance on average.

In the world we live in, none of these conditions will hold consistently, so the potential for policy-induced disasters is large. The U.S. economy prospered for its first 125 years without a central bank. It's time to try that approach again.

How could this be? After all, by November 1929, the stock market had started to recover, and by mid-April 1930, it had reached its pre-crash level. Contrary to the received wisdom, massive government failure — not the stock market crash — pushed the United States into the Great Depression. It was the Federal Reserve that ushered in that terrible nightmare. During the course of the Great Depression, the money supply contracted by 25%. This sent the economy into a deflationary death spiral, with the price level falling 25%.

The Federal Reserve was not the only culprit. In the name of saving jobs, the Smoot-Hawley trade bill became law in June 1930. That intervention increased U.S. tariffs by over 50%. It was quickly followed by the imposition of retaliatory tariffs in 60 other countries. In consequence, world trade collapsed and the unemployment rate in the U.S. surged from 7.8% in June 1930 to 24.7% in 1933.

In addition to the Smoot-Hawley tariff wedge, the Hoover administration and the Democratic Congress imposed the largest tax increase in U.S. history, with the top tax rate on income jumping from 25% to 63% in 1932. If these government policies weren't destructive enough, the Roosevelt administration's New Deal created regime uncertainty because major policies were being changed so rapidly. As a result, investors were afraid to commit funds to new projects and private investment collapsed.

Far from saving the patient, government intervention came close to killing it. But you wouldn't know it from listening to the current discourse about the Panic of 2008-09. Indeed, politicians and pundits throughout the world have unfortunately dialed back to the Great Depression and drawn on the false lessons of history for policy guidance and justifications for their mega-interventions.

In consequence, the key enabler of both the Great Depression and the Panic of 2008-09 — namely the Federal Reserve — is scheduled to become America's systemic risk regulator. This is the world upside down. The Federal Reserve is the systemic risk.

The true lesson to be drawn from business cycle history is that, if left to run their natural course, severe downturns are followed by rapid snapbacks. For example, during the 1921 recession, wholesale prices, industrial production, and manufacturing employment fell by 30% or more, reaching their low in mid-1921. But, absent government intervention, the economy recovered naturally, and by early 1922, it had fully recovered, from its mid-1921 low.

Never mind. The crisis has energized the interventionists. One of the most hyper-active is French President Nicolas Sarkozy. In addition to leading the charge to impose wage controls on top bankers, he has grand visions. He wants to move away from the "fetichism of GDP". The Sarkozy conjecture is that GDP metrics don't measure "happiness".

To correct that alleged flaw, President Sarkozy appointed a "Commission on the Measurement of Economic Performance and Social Progress". It is led by two Nobel laureates: Columbia University's Joseph Stiglitz and Harvard's Amartya Sen. The Commission's report, which was issued in September 2009, presents the known shortcomings associated with national income accounting, including the GDP metrics. That said, the Commission failed to produce any new, reliable measures that account for overall economic health. The commission will, no doubt, go down as a typical Sarkozy fireworks display, with no measured "happiness" at the end of the performance.

For the foreseeable future, GDP metrics, as well as other standard economic measures, will remain center stage for economists and policy makers. President Hu of China made this clear in a speech on climate change before the U.N. General Assembly in September 2009. While bowing to "greenery", China's President Hu stressed that developing countries should "go for growth".

This was a cold shower for President Sarkozy and other interventionists. After all, GDP growth and levels of GDP per capita are closely, and positively, associated with metrics that measure the vitality of free markets and the ease of doing business (see the accompanying table). And that's not all. Economic growth is, quite literally, a matter of life and death. As the accompanying chart indicates, prosperity (measured by standard metrics) affects life expectancy (health) in a positive way.

A reliable picture of an economic state of affairs can be obtained by constructing a misery index using standard measures: the sum of the inflation rate, plus the lending (interest) rate, plus the unemployment rate, minus the annual percentage change in GDP per capita.

As an example, the misery index for New Zealand is presented in the accompanying chart for the period 1980-2008.

By the early 1980s, New Zealand's economy was suffering from interventionism and its misery index was at record levels. Then Roger Douglas took over the reins at the Ministry of Finance and pushed through dramatic free-market reforms.

These set the stage for a significant initial fall in New Zealand's misery index. The second stage of the decline in the index occurred during Ruth Richardson's tenure as Minister of Finance in 1991-93, when she pushed through a number of additional liberal economic reforms. In late 1999, the Labour Party, with Helen Clarke at the helm, took power in New Zealand, where it stayed entrenched until November 2008. During that long stretch, the dramatic economic reforms of the late-1980s and early-1990s were eroded away and New Zealand's misery index more than doubled.

President Hu took note of the main lesson of economic history: "go for free markets" and prosperity and longevity will follow.

At the end of World War II, from 1945 to 1946, there was a very sharp drop in U.S. output (12.1 percent) as the war economy began its transition to a civilian economy. The deepest and longest-lasting recession the United States has experienced since then began in 1980, when Jimmy Carter was president (the gross domestic product dropped 9.6 percent in the second quarter of that year) and did not end until fourth-quarter 1982, almost two years into the Reagan presidency. There were positive quarters during this almost three-year period, resulting in what is known as a double-dip recession, but GDP did not return to the 1979 level until well into 2003. Unemployment peaked at 10.6 percent in the fall of 1982.

Both President Reagan and President Obama inherited an economy suffering from a year of no growth, along with rising unemployment. (The numbers are almost identical.) But Mr. Reagan faced a far direr situation in that inflation was in the double digits and the prime interest rate was at 20 percent. In contrast, Mr. Obama inherited an economy in which inflation was falling (in fact, inflation has been close to zero for this year) and interest rates were very low.

A situation in which the number of jobs available is falling is bad enough, but if inflation is also destroying purchasing power, the misery is compounded. In the 1960s, economist Arthur M. Okun created the Misery Index by adding the unemployment rate to the inflation rate. In the 1976 presidential race, Jimmy Carter frequently attacked President Ford for allowing the Misery Index to reach 13.57, even though it was lower when Mr. Ford left office than what he had inherited from the Nixon years. Ironically, four years later, when President Carter was running against Ronald Reagan, the Misery Index reached a record high of 21.98. Mr. Carter had no defense and lost the election. The Misery Index dropped by more than 10 points during the Reagan presidency, the single largest improvement during any president's tenure in the last half-century.

Economists do not fully agree on the precise definition of a recession, even though a recession is commonly referred to as two or more consecutive quarters of negative economic growth. The private National Bureau of Economic Research (NBER) has served as an authority for defining recessions in the United States. The NBER uses a number of factors - including judgment and not just GDP changes - to characterize a recession. Other economists and organizations, such as the International Monetary Fund, use different definitions than the NBER. Recessions may be as short as eight months, like the 1990-91 and the 2001 recessions, or may continue for a couple of years. Depressions normally are defined as a downturn of 10 percent or more, lasting for more than four years.

President Obama has taken the polar opposite approach to President Reagan's to reignite the economic-growth engine. Reagan pushed for cuts in marginal tax rates to encourage people to work, save and invest in an effort to spur the supply side of the economy as well as the demand side. Mr. Obama has chosen only to greatly increase government spending in an attempt to increase demand while, at the same time, many of his new labor, environmental, energy and other regulations are impeding the supply side of the economy.

Mr. Obama had the advantage of both houses of Congress being controlled by his party, so he was able to get his stimulus package passed within a few weeks of taking office. Reagan was handicapped by having the opposition party in control of the House of Representatives, whose members both delayed (until August 1981) and reduced his tax-reduction stimulus package.

In fact, the Reagan tax cuts were not fully phased in until 1983, more than two years after he assumed office. Reagan, hobbled by an opposition Congress, was not able to get the spending-growth restraint he wanted, so substantial budget deficits occurred early in his administration, at one point reaching 6 percent of GDP. In retrospect, the Reagan deficits look small compared to the deficit of 13.5 percent of GDP this year and the Obama administration and Congressional Budget Office projections of huge deficits in the years to come.

Once Reagan's tax cuts were largely phased in, the economy took off - it grew by 7.6 percent in 1984 alone. We are in the midst of a most interesting experiment. The administration and the CBO forecast moderate and uninterrupted economic growth between the end of this year and 2019. If they are correct, 1980-82 - not the current recession - will remain the longest sustained period without economic growth since World War II. If they are wrong, they indeed will have the worst economic downturn since the Great Depression and no one to blame but themselves.

We are skeptical that economists can detect bubbles in real time through technical means with any degree of unanimity. Even if they could, we doubt the Fed would have altered its policy in the early 21st century, and we suspect that political leaders would have exerted considerable pressure to maintain that policy. Concerning regulation, we find that the banking reform of the late 1990s had little effect on the housing boom and bust, and that the many reform ideas currently proposed would have done little or nothing to avert the crisis.

Commentators have also argued that the popularization of financial products such as teaser-rate hybrid loans for subprime homebuyers and credit default swaps for investors is to blame for the financial crisis. We find little evidence for this. Housing data indicate that the majority of subprime hybrid loans that have entered default had not undergone interest rate resets, and the default rate for subprime hybrid loans is not much higher than for subprime fixed rate loans. Concerning swaps, although their introduction may increase financial inflows into risky sectors, their execution through a clearing-house or regulation via other means would not necessarily have avoided the mispricing of risks in underlying contracts. Capital requirements for the credit default swaps that were used to insure mortgage-backed securities would have been low because housing investments were not considered risky.

How should we design our financial and regulatory institutions? The lesson from the 1970s was that rampant inflation and unchecked inflation expectations would eventually create obstacles to proper resource allocation and growth. So we established the Fed's mandate to promote maximum growth while delivering price stability. The current episode suggests that the Fed's current policy goals and instruments are not sufficient to prevent "inflationary" asset prices and price expectations.

The knee-jerk response by some observers has been to blame the Fed's conduct of monetary policy. Some observers suggest that the Fed should regulate financial companies more tightly, others that it should broaden the definition of price stability to include asset prices, and yet others that the Fed's objectives should be broadened to include prevention of asset price bubbles.

Some observers, especially European policymakers, have called for tighter regulation of financial institutions under a new global financial architecture. And the immediate response of governments all over the world has been to attempt to salvage the existing financial institutions, instruments, and arrangements by injecting massive taxpayer funds into the financial companies that are skirting economic collapse.

When will this process end and where will it lead? Recent government interventions have now almost certainly created expectations of similar future bailouts during the next financial crisis. That means banking institutions will feel more at ease in expending considerable efforts at skirting whatever new regulations are created to prevent a similar financial crisis from recurring.

Thus, the cat-and-mouse game of regulatory arbitrage in search of profits may intensify, rather than disappear, as a result of adopting stricter financial regulations. But, for a time, stronger capital and risk regulations may stifle financial intermediation and slow the pace of recovery from the current recession.

Some analysts are proposing the adoption of smart regulations that are sequenced and modulated according to movements in macroeconomic variables such as the capital standards that vary with the business cycle. One could call such regulatory measures "financial automatic stabilizers." However, as recent experience with fiscal stimulus packages shows, political pressures prevent politicians from leaving such systems well enough alone.

Any whiff of financial-sector problems will incite Congress and Treasury bureaucrats to tinker with the rules. Which institutions and officials are likely to be sufficiently prescient to correctly calibrate such regulations each time the financial sector hiccups? And would politicians be able to resist calls for regulatory relief when financial sector lobbyists flood their offices as profit opportunities surge? Even more likely, any new regulatory attempt to globally control profit-driven risk-taking will spur new attempts to circumvent regulations.

The key lesson from the current financial crisis and recession is that a government-imposed financial architecture is unlikely to persist for any significant length of time. Global market developments, and the need to channel resources toward opportunities perceived to be the least risky and most profitable, will continue to modify institutional financial arrangements. Imposing onerous financial regulations will only impede the reconstitution of financial institutions, delay the recovery, and dampen the pace of long-term economic growth.

There are several ways to see if it is working as advertised. First, what did the proponents say would happen when they were pushing the plan versus what has happened? Second, how has the United States fared compared to other nations that had smaller or no stimulus programs? Third, how have the results to date compared to what pro-stimulus, Keynesian-school economic theorists advocated versus what other theorists (principally Austrian-school) who largely opposed the stimulus plans said?

U.S. unemployment already has reached 9.8 percent, with 15.1 million Americans unemployed, and more than 7.1 million jobs have been eliminated since the beginning of the recession. President Obama's economic advisers said in the beginning of this year that the unemployment rate would rise to 9 percent with no stimulus package and would only rise to a maximum of 7.9 percent with the stimulus bill, peaking during this past summer. Stimulus proponents clearly have failed the first test (despite Vice President Joseph R. Biden Jr.'s revisionist statements) and there is zero evidence for their claims that more jobs would have been lost without the stimulus package.

One might argue that the stimulus had worked if the results in the United States were better than in other countries that had smaller or no stimulus packages. The recession has been global, and every country has been affected negatively. Only Great Britain attempted to put in a stimulus package that was relatively as large as the U.S. package. A crude measure of economic stimulus is the size of the deficit relative to gross domestic product. During recessions, tax revenues decline in all countries, so most will run a deficit whether they intend to or not. A stimulus package normally contains a mix of government spending increases and tax cuts, resulting in a deliberately larger deficit.

The United States and Britain have by far and away run the largest deficits as a percentage of GDP (i.e. the most stimulus), yet the U.S. and Britain, along with Italy and Russia, had not bottomed out in second-quarter 2009, while the rest of the 10 largest economies were showing real growth in the second quarter. Russia's poor performance is largely a function of relying very heavily on the export of raw materials rather than developing a broad-based economy as all the others in the Big 10 have done.

The three countries with the smallest deficits (the least stimulus) — Brazil, China and Germany — have all turned the corner rather quickly and are growing. German Chancellor Angela Merkel has just announced she is going to push tax cuts, which should give the German economy an additional shot in the arm.

While the data set is too small with the top 10 countries (which collectively account for a large majority of the world's GDP) to draw definitive conclusions, the existing evidence indicates that a big stimulus package seems to delay recovery, while little stimulus leads to a quick return to economic growth.

Finally, what do the competing economic theorists say? The Keynesians say that if the government increases spending to stimulate demand and create jobs for those who do not have them, this should lead to a less painful downturn and a quicker recovery. The Austrian (aka Hayekians) free-market sorts say recoveries occur on their own once asset and labor prices fall from inflated levels of the previous boom and excess inventories are worked off. This usually happens within 16 months unless government attempts to mitigate these necessary price adjustments, which will delay the recovery. (Apologies to both my Austrian and Keynesian friends for trying to summarize their views in one short paragraph.)

The Keynesians never really get a fair test of their theory because politicians always take the Keynesian notion that it is OK to increase government spending as a license to spend the extra money on themselves and their friends rather than on those who might actually benefit. (This self-dealing process is well explained by the public-choice school of economics.) A few examples from the current stimulus program should suffice. Congress increased spending on itself last year by 10.9 percent and by another 5.8 percent this year for a grand total of $4.7 billion. (Remember, it was just 15 years ago when the Gingrich Republicans ran against the "billion dollar Congress.") Given that the number of members of Congress remains fixed at 535, why should their budget go up any faster than inflation?

Congress and the administration also have gotten into the venture capital business, which enables them to dump infinite quantities of money into their rich friends' pockets. Bill Frezza, a principled venture capitalist, using Fox News and other venues, has been blowing the whistle on these unsavory and destructive practices. Did you know that Al Gore and friends just received almost $600 million to develop another expensive ($88,000) hybrid electric sports car with your tax money? The chances of taxpayers getting their money back are less than of General Motors Corp. and Chrysler paying off all their loans, which is close to zero. Paradise defined: being politically well-connected when stimulus money is around.

The only things one can say for sure about stimulus money is that it will add to the deficit, ultimately driving up interest rates and taxes; and much of it will be wasted and/or stolen, neither of which benefits the unemployed. By any objective measure, the stimulus program has been and will continue to be a failure — but don't expect the Washington politicos ever to admit it.

Commentators have also argued that the popularization of financial products such as teaser-rate hybrid loans for subprime homebuyers and credit default swaps for investors is to blame for the financial crisis. We find little evidence for this. Housing data indicate that the majority of subprime hybrid loans that have entered default had not undergone interest rate resets, and the default rate for subprime hybrid loans is not much higher than for subprime fixed rate loans. Concerning swaps, although their introduction may increase financial inflows into risky sectors, their execution through a clearing-house or regulation via other means would not necessarily have avoided the mispricing of risks in underlying contracts. Capital requirements for the credit default swaps that were used to insure mortgage-backed securities would have been low because housing investments were not considered risky.

In addition, you learned that the federal government (i.e., taxpayers) now owns (primarily through Fannie Mae and Freddie Mac) or insures (through the Federal Housing Administration and other government programs) about 80 percent of the $14.6 trillion of home mortgages outstanding in the United States. Last week, Congress passed a bill requiring all student loans be made by the federal government rather than banks, which means the taxpayers will be 100 percent liable for any student loan defaults.

You also learned that the Federal Deposit Insurance Corp. is considering tapping its Treasury credit line for up to $500 billion. It needs to do this because of the high number of bank failures and because each bank account is insured by the government (i.e., taxpayers) up to $250,000. The president and many in Congress are calling for a roughly $1 trillion health care bill — paid for by additional debt and/or more taxes, which will further slow economic growth, eventually leading to even more debt.

Finally, you also became aware of the following facts: Federal government expenditures are growing far faster than the economy, and thus the government is becoming a larger and larger share of gross domestic product. Obviously, this cannot continue forever because eventually the government would totally drive out the private sector.

The entitlement programs (i.e., Social Security, Medicare, Medicaid, etc.) all continue to grow faster than the economy, and they will take more than 100 percent of all federal tax revenue this year, requiring that virtually all of the other government spending programs, including defense and interest payments on the debt, be funded by more borrowing.

You are also aware that the government cannot tax its way out of the deficit situation, because increasing income tax rates on the upper income people will both slow the economy and cause them to find legal or illegal ways to avoid the tax increase, and the politicians have pledged to not increase taxes on those making less than $250,000, which includes all but a very few Americans.

Even if the politicians break their pledges not to increase taxes, they still cannot solve the deficit problem as long as they refuse to cut back on the growth in Social Security, Medicare, and Medicaid — because any new tax revenue will be quickly absorbed by the growth in spending. The best that any tax increase could do is delay the explosion of the debt bomb by, perhaps, a couple of years while further weakening the economy and job growth.

Now suppose you are not an individual bondholder but the Chinese government official responsible for the Chinese economy, and you know your government holds about $1 trillion in U.S. government securities. You have watched Congress and the administration become less and less fiscally responsible — more spending, more taxes, and more debt.

Then suddenly the administration puts punitive tariffs on your tire manufacturers while at the same time refuses to approve the trade treaties with Colombia, Panama and South Korea that have been negotiated.

You understand that these foolish and destructive actions by U.S. government officials indicate it does not understand the importance of free trade in fostering economic growth, and seem to be intent on replicating the mistakes of the 1930s.

The Chinese are not stupid, and they have been vocal in saying they are concerned that U.S. policies will lead to a further fall in the dollar and higher rates of inflation, both of which undermine the value of their investment in U.S. government securities.

The Chinese are now trying to diversify their holdings — and their recent activity in buying large quantities of tradable commodities is probably, in part, a hedge against a falling U.S. dollar. Thus, at the same time, the U.S. government needs to sell trillions of dollars of new bonds. It is by its own actions driving away foreign purchasers of bonds, which can only result in higher interest rates in the United States, which will further slow economic growth.

What is particularly frightening is that neither political party has offered a serious plan to defuse the debt bomb. The Democrats are just piling up more debt as if there were no limit, and the Republicans, to date, are only proposing measures to reduce the increase, rather than reverse it. When the debt bomb explodes — within the next one to three years — expect to see record high real interest rates and/or inflation, coupled with a collapse of many "entitlements." It will be like the neutron bomb, the buildings will be left standing, but the people will not.

But we must never forget that the light at the end of the tunnel can be an approaching train.

All of these presumably positive signs could also be interpreted as problems. They might contribute to a slower rebound than expected, and possibly to a new crisis further down the road.

It is counterintuitive, but the fundamental economic problem was not the "bust"— it was the "boom," under which too much wealth was put to inefficient use.

The recession is the period when we wind down investments and put capital and labor to use in more competitive and sustainable businesses. If this redeployment of resources is not allowed to proceed because of bailouts and stimulus programs, old mistakes will survive and drag us down in the future as well.

A famous Austrian economist, Joseph Schumpeter, warned that recovery is sound only if it comes of itself. A government stimulus "adds, to an undigested remnant of maladjustment, new maladjustment of its own which has to be liquidated in turn, thus threatening business with another crisis ahead."

That is where we are right now. The financial crisis is the result of too much cheap credit, too much indebtedness and too many bad investments. So it is ironic that governments are trying to meet the crisis with . . . even cheaper credit, even more indebtedness, and attempts to subsidize and protect bad investments and overproduction — in the housing sector, the car industry, and everything in between.

The zero percent interest rate, new liquidity facilities, and bailout loans were supposed to unblock the credit market. But they also can result in new investment mistakes, as companies and households base their behavior on interest rates that are unsustainable.

The more investment depends on today's rates, the more reluctant central banks will be to increase them, and even more misguided investments will be made. We have been here before.

Governments have worsened the situation by bailing out some of the most insolvent and uncompetitive businesses.

By saving car companies, we are guaranteeing a continued overproduction of cars. The very idea of the massive stimulus is to subsidize projects that would not survive the market's cost-benefit analyses.

It seems like politicians want to keep failed investments on artificial life support until economic growth makes it possible for them to survive on their own. But since that means resources are locked into the least productive sectors, this strategy will result in a delayed return to healthy economic growth.

The bailouts also distort future incentives. Goldman Sachs' record second-quarter profits took attention away from the fact that its value-at-risk was at an all-time high.

So just half a year after the U.S. government saved insurer AIG because its collapse would have destroyed Goldman Sachs — and after the investment bank had been injected with $10 billion of taxpayer money (later repaid) — the bank has taken on enormous risk.

It seems like a paradox, but in another way it is perfectly logical. Banks have ample evidence that the government has provided them with a multidimensional safety net, so why not take risks for short-term gains if you can send potential losses to the taxpayers?

The problem with all of these policies is not only what they buy, but also what they cost. The debts that are now building will burden countries for a very long time, especially since we already have growing unfunded liabilities in our social security systems to worry about.

The risk is growing that governments will further inflate those debts with monetary policy, which, according to Schumpeter's prophecy, "would, in the end, lead to a collapse worse than the one it was called in to remedy."

It is somewhat understandable why the risk of a 1930s-style depression has led some to call for unprecedented action. One central policymaker has even said the economy has to be saved in the short-term by a monetary stimulus, even if we thereby "foster a bubble, an inflationary boom of some sort, which we would subsequently have to address."

But let's keep in mind that argument came from then-Fed Chairman Alan Greenspan when he introduced 1 percent interest rates in 2003. That "inflationary boom" ended up in real estate; we are now in the "subsequently," and we have to address it.

As Mark Twain pointed out, history does not repeat itself, but sometimes it rhymes.

But bankers are not the only ones we should look at in a new light. Another casualty of the crisis should be belief in the powers and virtues of government regulators, because their fingerprints are all over the crime scene as well.

There are 39,000 individuals working full time to regulate the financial markets in the U.S. alone. What did they do when the bubble was inflated? Well, they helped inflate it.

In the 1970s and 1980s, we learned that regulation of product markets caused many problems. The public choice school taught us that when regulators have to choose between increasing their powers and budgets and what improves society, they often choose the latter. Even well-meaning regulation often produces unintended consequences that turn small problems into big ones.

But when the financial markets seemed to be doing reasonably well, that criticism never really had an impact on the world of finance.

What a difference a crisis makes! A detailed anatomy of the bubble shows that many of the policies and regulations meant to reduce financial risk actually increased it. The most obvious example is the government's policy of bailing out financial institutions to avoid crises, which made it more likely that they will engage in risky behavior. And the Fed's attempt to abolish recessions with drastic reductions of the interest rate it sets resulted in the biggest credit bubble in history, and one of the worst recessions.

But there are several other examples in this crisis. In the 1970s, the SEC gave the big rating agencies a regulatory role. They got the right to officially define risk, and other investors were forced to abide by them; many funds were not allowed to invest in anything that was not considered investment grade, and other institutions were forced to hold more capital if they did.

This oligopoly was granted in order to control risk. But the institutions used their new role to inflate the ratings, and dangerous mortgage-backed securities were suddenly considered risk-free. The deal would get the same generous treatment even if it was structured by cows, as an analyst at a big rating firm said in an internal discussion. Since the cows paid well, and the market was forced to follow the ratings anyway, why not?

The banks did not hold these securities in a transparent way, but in the opaque "shadow banking sector, " in an attempt to reduce risk. The smartest bank regulators in the industrialized world met for six years to produce the Basel agreements on capital requirements for banks. Their requirements made it expensive for banks to hold assets - like mortgage-backed securities - on their balance sheets, but very profitable to put them in non-transparent conduits or vehicles financed by short-term loans on the market.

So even if the best and the brightest introduce regulation because they think it is in mankind's best interest, there are unintended consequences. Indeed, bureaucracies and governmental authorities also have their own agendas and their own interests, and sometimes that trumps social welfare. One reason why financial regulators did not notice what was going on was that they were engaged in turf war. One former SEC commissioner admitted that his agency failed to develop open marketplaces for mortgage-backed securities because it was "distracted." The object of its time and resources: grabbing power from other government agencies by starting to regulate hedge funds and introduce new types of supervision of mutual funds.

We need to take another look at regulation. The world is a complex place, and often progress is made by trial and error. Introducing a standard means confining everybody to the present knowledge of the bureaucrats, and preventing individuals and businesses from adapting to new information as it is discovered. This cannot be avoided in every instance, but it is important to always evaluate it critically and to keep unregulated parts of the economy unregulated so that we don't put all of our eggs in one basket.

The unregulated hedge funds were still standing and supplied the economy with liquidity when everything else failed last September, partly because they were not subject to the same capital requirements as other sectors. If the attempts to regulate them now were to succeed, we would give all financial actors the same Achilles' heal. It might not be likely that this is the heel that will be hit the next time, but if it is, everybody falls at the same time.

Do not expect too much from new regulations. Tomorrow's crisis is often a result of the solution to the last crisis.

But did he?

Trying to challenge Mr. Bernanke's job performance is like trying to convince your average ancient Greek that Zeus was a bumbling weakling. That's because the mystique surrounding the Fed's ordinary actions — let alone its recent, extraordinary ones — is thicker than the fog at Mt. Olympus's summit. People entertain perfectly absurd beliefs concerning what the Fed can — and what it can't — do; and while some like to blame the Fed for every economic hiccup, others are no less convinced that the economy would drop dead were it not for its constant care.

One doesn't usually turn to old TV shows for economic insights. Yet the best way to put the Fed's role in the recent crisis in perspective is by recalling an episode of The Beverly Hillbillies — the one in which Granny convinces everyone that a spoonful of her medicine can cure the common cold. Sure enough, it can: It just takes between a week and 10 days.

Recessions don't peter out in 10 days, of course. But they do eventually end, with or without central bankers' help. According to the National Bureau of Economic Research, the US went through 32 recessions between 1854 and 2001, the average duration of which was about 17 months — or a few months shorter than the current recession, so far.

Even a severe downturn can be followed by rapid recovery without aggressive central bank intervention. In the 1921 recession, wholesale prices, industrial production, and manufacturing employment all fell by 30 percent or more within a year. Yet by early 1922, the US economy had recovered fully from its mid-1921 low. What's more, it did so with no help from the Fed, which was determined to let the recession take its course, so as to hasten the restoration of the prewar gold standard.

Bernanke, in contrast, has been praised for taking bold, innovative measures to tame a supposedly unprecedented economic collapse. But his innovations included errors of both commission and omission that almost certainly deepened the recent downturn, making it last that much longer.

Until the late summer of 2008, the Fed responded to what was really a solvency crisis as if it were a liquidity crisis, establishing the Term Auction Facility in December 2007 and dramatically lowering its interest rate target. Yet while it was taking these steps, the evidence pointed not to a liquidity shortage, but to fears of counterparty exposure to losses on mortgage-backed securities, as the cause of the credit squeeze. The Fed's actions, both on its own and in conjunction with the US Treasury, did nothing to allay those fears.

On the contrary: they compounded them by throwing good money after bad, rewarding imprudent financial firms at the expense of their more prudent rivals, including prospective buyers, while unsettling financial markets all the more by suggesting that even Bernanke himself was tossing in the towel on old-fashioned monetary policy.

Starting in the late summer of 2008, the Fed erred the other way. Thanks partly to its (and the Treasury's) previous missteps, including scare tactics used to cow Congress into approving the Treasury's bailout plan, a genuine liquidity crisis had taken hold by then. Yet the Fed resisted a much-needed loosening of monetary policy until early October. Then, although it finally took steps to aggressively expand bank reserve credits, it undermined the potential stimulus effect of doing so by starting a new policy of paying interest on bank reserves. In short, the Fed behaved much as it had back in 1936-37 when, fearing inflation (of all things), it decided to double bank reserve requirements, plunging the US back into the Great Depression from which it was struggling to emerge.

In many ways, Bernanke was dealt a tough hand when he became chairman. The Fed made lots of mistakes earlier this decade — primarily, holding interest rates too low for too long — that weren't entirely his fault.

But when the crisis hit during his watch, he faced a choice: He could have stuck to orthodox rules that would have helped sever the link between the housing market collapse and recession, by keeping Fed firmly focused on the goal of preserving the overall availability of liquidity to the banking system. Instead, he took the lead in developing wasteful, ad-hoc handouts to individual banks that often didn't need or weren't worthy of them. A strict focus on its traditional duty of maintaining sound banks' access to funds would also have kept the Fed from actually undermining bank solvency by subsidizing imprudent firms.

If Congress really wants to encourage Bernanke to successfully combat future recessions, it needs to take steps to force him to stick to traditional monetary policy procedures, instead of congratulating him for innovations that may well have done more harm than good. After all, no one congratulates Granny, and she never did anyone any harm.

The narrative in Washington is that competition among financial regulators allowed financial institutions to choose the weakest regulator, and also encouraged regulators to weaken their supervision and enforcement in order to attract more entities toward their charter. This drives the call by Democrat congressional leaders and the Obama administration for the elimination of both the Office of Thrift Supervision (OTS) and the Office of the Comptroller of the Currency (OCC), and their merger into a single "super" bank regulator.

But is this narrative more than mere assertion? Fannie Mae and Freddie Mac could not choose their regulator, nor could Bear Stearns or Lehman Brothers. The worst-performing U.S. institutions at the very center of the crisis had no choice in their regulator.

And of course, this was not simply a U.S. crisis. Northern Rock had no ability to choose its regulator. The U.K., like much of the world, does not have multiple bank supervisors, but only a single supervisor. In fact, only three developed countries have multiple bank supervisors: the United States, Germany and Liechtenstein. And only in the U.S. is there any real degree of competition between bank regulators. If this were a crisis driven by competition among bank regulators, then most of the world would have been spared.

Why then merge the OTS and the OCC? Apparently the proposal rests upon the observation that both AIG and Countrywide owned thrifts at the time of their failure. In addition, the failure of thrift IndyMac was one of the largest bank failures to date. Not long after came the failure of Washington Mutual (WaMu). Therefore, the OTS must have been the weak link.

However, both AIG and Countrywide acquired federally chartered thrifts late in the game; their failures were already "baked in the cake" long before they acquired thrifts. Their thrift subsidiaries were also very small parts of their balance sheets. And in neither case did their failure result from their thrift subsidiaries.

In relation to IndyMac and WaMu, the entities regulated by the OTS specialize in mortgage finance; hence it should not be surprising that in the aftermath of a housing bubble, those engaging in mortgage finance fail at a greater rate. More importantly, neither the failure of IndyMac or WaMu cost the taxpayer a dime. The market disruption from their failures was minimal.

Prior to the savings and loan crisis, when there really was a significant difference between bank and thrift charters, thrifts could not choose to maintain their current business model and also flip charters, yet that lack of regulatory competition did nothing to help avoid the S&L crisis.

The competition that does occur among bank regulators is the result of our dual state-federal banking system. However, Obama's proposal includes no mention of changing that dual system.

The real desire for consolidation is revealed in Secretary Geithner's regular attempts to silence the independent bank regulators. The different perspectives of Sheila Bair, John Dugan, John Bowman and Ben Bernanke have offered valuable insights into the regulatory debate. Silencing these voices will not help avert the next crisis, nor will it improve the quality of current reform efforts. Creating a single bank regulator, under the supervision of the Treasury secretary, would deprive Congress and the public of much needed diversity in views on bank regulation.

To the extent that concerns about charter shopping are valid, there is an easier and more effective fix than merging regulators: Require the FDIC to base deposit insurance premiums on the historical and expected losses by charter. One could also require the FDIC to base premiums upon the location of the bank as well. There's no reason for the rest of the country to subsidize the risky behavior of California-based mortgage lenders.

The administration should abandon its knee-jerk ideological opposition to competition and recognize that in many parts of our financial system, such as with Fannie and Freddie or with the credit rating agencies — it was the lack of competition, not its abundance, which contributed to the crisis.

Representative Barney Frank, the colourful chairman of the powerful House Financial Services Committee, put it this way: "This is the end of the era of extreme laissez-faire, of 'don't tax it, don't regulate it'. That has now been totally evaporated." Pundits have also swung into action. For example, The New York Times columnist Paul Krugman wrote: "For the more one looks into the origins of the current disaster, the clearer it becomes that the key wrong turn - the turn that made crisis inevitable - took place in the early 1980s, during the Reagan years."

To evaluate these claims, an index of economic "misery" for each US administration since World War II is presented in Chart 1. The original misery index was developed by the late Arthur Okun, a distinguished economist who served as chairman of the President's Council of Economic Advisers in the Johnson administration. Okun's index equals the sum of the inflation and unemployment rates.

While Okun's index measures the absolute level of misery in the economy, it tells us little about whether things are getting better or worse. In Getting It Right (1996), Harvard Professor Robert Barro amended the Okun index. Barro's index, which measures the change in misery during a president's term, is the sum of the following four metrics: the difference between the average inflation rate over a president's term and the average inflation rate during the last year of the previous president's term; the difference between the average unemployment rate over a president's term and the unemployment rate during the last month of the previous president's term; the change in the 30-year government bond yield during a president's term; and the difference between the long-term, trend rate of real GDP growth (3.1 per cent) and the real rate of growth during a president's term.

These modifications had several effects; the data were smoother and more comprehensive, painting a more accurate picture of economic conditions experienced by the majority of Americans. Indeed, Barro's modifications allow one to measure more accurately the relative change in the economy over a US president's four years in office.

The data in the misery index chart speak loudly. Contrary to what has become dogma in some quarters, the Reagan "free-market years" were very good ones. And the Clinton era of Victorian fiscal prudence - when President Clinton proclaimed in his January 1996 State of the Union address: "the era of big government is over" - was also excellent. In general, the Reagan and Clinton periods were characterised by strong growth coupled with improvements in inflation, employment and interest rates.

The misery index pours cold water on the current critique of free markets - one that has taken on the characteristics of a religion. It makes one wonder if the critics actually tested their ideas by comparing them with anything that actually happened.

To obtain an economic reality check, the misery index concept can be applied to any country where suitable data exist. Let's take a look at Jamaica. A modified misery index for Jamaica is presented in Chart 2. The index is the sum of the inflation, interest, and unemployment rates, minus the annual per cent change in per capita GDP.

Several things stand out: the Manley years (1972-80 and 1989-92) were a disaster that Jamaica has never recovered from; the Seaga years (1980-89) were a bit of a rollercoaster ride, but one in which Seaga, by the end of his term, had improved on the mess that he had inherited from Manley; the Patterson years (1992-2006) were marked by a steady improvement on the dismal state of economic affairs created by Manley during the 1989-92 period; both Simpson Miller and Golding have ushered in a reversal of the downward trend in the misery index realised during the Patterson years. Jamaica remains with an elevated level of economic misery. And what is worse, the economy is pointed in the wrong direction.

As an indication of just how far Jamaica will have to travel before it reaches a state of tolerable economic health, consider that Jamaica ranks 63 out of the 181 countries graded in the World Bank's "Doing Business 2009" - a report that measures the vitality of free markets and the ease of doing business.

To get a handle on these claims, a misery index reading for each U.S. administration since World War II is presented in the accompanying chart. The original misery index was developed by the late Arthur Okun, a distinguished economist who served as chairman of the President's Council of Economic Advisers in the Johnson administration. Okun's index equals the sum of the inflation and unemployment rates.

While Okun's index measures the absolute level of "misery" in the economy, it tells us little about whether things are getting better, or worse. In Getting It Right (1996), Harvard professor Robert Barro amended the Okun index. Barro's index, which measures the change in misery during a president's term, is the sum of the following four metrics: the difference between the average inflation rate over a president's term and the average inflation rate during the last year of the previous president's term; the difference between the average unemployment rate over a president's term and the unemployment rate during the last month of the previous president's term; the change in the 30-year government bond yield during a president's term; and the difference between the long-term, trend rate of real GDP growth (3.1%) and the real rate of growth during a president's term.

click on chart for larger view

These modifications had several effects; the data were smoother and more comprehensive, painting a more accurate picture of economic conditions experienced by the majority of Americans. They also allowed Barro to measure more accurately the relative change in the economy over the four years of a presidential term.

The data in the misery index chart speak loudly. Contrary to left-wing dogma, the Reagan "free-market years," were very good ones. And the Clinton years of Victorian fiscal virtues – when President Clinton proclaimed in his January 1996 State of the Union address: "the era of big government is over" – were also very good ones.

click on chart for larger view

The misery index pours cold water on the current critique of free markets – one that has taken on the characteristics of a religion that is embraced without investigation. Indeed, it makes one wonder if the critics tested their ideas by comparing them with anything that actually happened. To obtain an economic reality check, the misery index concept can be applied to any country where suitable data exist. Let's take a look at Indonesia.

A modified misery index – using all four of Barro's metrics for the last two decades in Indonesia – is presented in the accompanying chart. The index is a simple sum of interest, inflation, and unemployment rates, minus year-on-year GDP growth. Most apparent in the chart is a large jump during the Asian financial crisis of 1997 and 1998. The index normalizes quickly by 1999, however. Indeed, it made new lows during the next decade. While Indonesia's economy follows the rhythms of the world economy, it is evident that Indonesia has experienced little improvement in basic levels of economic "misery" during the past twenty years. Successive administrations have failed to significantly bring misery rates down to the levels of Western economies, as many of their regional peers have done. There remains quite some distance to be traveled.

As an indication of just how far, consider that Indonesia ranks 129 out of the 181 countries ranked in the World Bank's Doing Business 2009 – a report that measures the vitality of free markets and the ease of doing business.

Trying to show the softer side of the central bank, Fed Chairman Ben S. Bernanke took us on a tour of his hometown of Dillon, S.C. on a 60 Minutes segment in March, and in July he fielded questions from newsman Jim Lehrer and an auditorium full of people for more than an hour in a televised town hall meeting.

Both events were carefully choreographed — and unprecedented. During his face time Bernanke explained many things, including the Fed's strategy for shrinking its balance sheet and withdrawing the ocean of excess reserves from the banking system. Unfortunately, he did not address my main beef with the bank: that it clings to a flawed inflation-targeting regime with a horrible history of monetary policy failures.

In pursuit of inflation targeting — the idea that monetary policy should be geared to keeping the annual core inflation rate in a range of, say, 0% to 2% — the Fed has been much more tolerant of inflation than it has of deflation. In November 2002 then governor Bernanke and then chairman Alan Greenspan misdiagnosed a benign cyclical dip in the price level. Fearing deflation, the Fed panicked, and by July 2003 pushed the Fed funds rate down to a then record low of 1%, where it stayed for a year, allowing a flood of liquidity to hit the economy and the housing bubble to inflate. The Fed ignored economic theory developed by Austrian economists such as Nobel laureate Friedrich Hayek, who demonstrated that there was such a thing as a "good deflation," which occurs during a productivity boom. It was just such a boom, coupled with an improvement in the U.S. terms of trade, that was putting down downward pressure on the core inflation rate.

More monetary blundering occurred after the Dubai G7 Summit in September 2003, when the U.S. got other Western nations on board to pressure China to allow its currency to appreciate against the dollar. The 2004 elections were approaching, and the outcome of key contests in the Rust Belt, according to President Bush's advisors, hinged on whether China could be forced to alter its fixed yuan-dollar exchange rate of 8.28. Surprisingly, the Fed was drawn into what is normally the exclusive domain of the U.S. Treasury — the dollar's exchange rate.

The Bush Administration's weak dollar policy, endorsed by the Fed, brought with it not only a dollar rout but also an explosion in commodity prices. Perhaps the commodity price surge explains why the Fed was behind the curve in lowering the Fed funds rate — something that pushed the economy into a steep recession well before the collapse of Lehman Brothers one year ago. By the start of 2007 weak aggregate demand was signaling a recession, but the Fed kept the funds rate at 5.25% until mid-September 2007. It's not surprising that the economy tanked.

Never mind these missteps. The Obama Administration has proposed rewarding the Fed for its failures by crowning it the nation's systemic regulator — a sort of financial regulatory czar. But many in Congress demand a closer peek inside the central bank.

Congressman Ron Paul (R–Tex.), along with 282 cosponsors, has introduced a bill that would require the Government Accountability Office to audit the Fed. The Fed claims that auditing would imperil its independence.

Milton Friedman weighed in on central bank independence in a 1962 essay, "Should There Be an Independent Monetary Authority?" Friedman's conclusion: "The case against a fully independent central bank is strong indeed." As for letting in some sunshine, the late senator Patrick Moynihan (D–N.Y.) had it right: "Secrecy is for losers."

As we await the outcome of the battle over Fed transparency, we should ponder a recent conclusion of Carnegie Mellon's Allan Meltzer. As the author of the authoritative A History of the Federal Reserve, he has observed that the Fed responds "decisively to the unemployment rate but not to the inflation rate." As long as unemployment remains elevated, expect loose monetary reins and more inflation.

Protect yourself with some exchange-traded funds. Buy SPDR Gold Shares (GLD, 93; expense ratio, 0.4%), which tracks the metal. I also recommend diversified commodity ETFs like the iShares S&P GSCI Commodity-Indexed Trust (GSG, 30; 0.75%) and PowerShares DB Commodity Index Tracking Fund (DBC, 23; 0.75%).

This is certainly a novel theory of the business cycle. To be taken seriously, however, any such explanation of recessions and recoveries must be tested against the facts. It is not enough to assert the U.S. economy would have experienced a "second Great Depression" were it not for the Obama stimulus plan.

Even those who think government borrowing is a free lunch can't possibly believe the government has already done enough "stimulus spending" to explain the difference between depression and recovery.

CNNMoney recently calculated that the stimulus plan has spent just $120 billion — less than 1% of GDP — mostly on temporary tax cuts ($53 billion) and additional Medicaid, food stamps and unemployment benefits. Less than $1 billion has been spent on highway and energy projects. Commitments for the future are much larger, but households and firms can't spend commitments.

Proponents of Big Government can't say we avoided the next Great Depression due to hypothetical stimulus money that is mostly unspent. So they argue it's more important that the federal government merely continued spending and didn't "slash" spending as in the early 1930s. But the federal government didn't slash spending in the early '30s. Federal spending rose by 6.2% in 1930, 7.7% in 1931 and 30.2% in 1932. Since prices were falling, real increases in federal spending were huge during the Hoover years.

President Obama clearly believes Big Government is the antidote to this and perhaps all recessions. At his first news conference in February, the president said, "The federal government is the only entity left with the resources to jolt our economy back to life." Yet that raises a key question: If the U.S. economy could not recover without a big "jolt" of deficit spending, then how did the economy recover from recessions in the distant past, when the federal government was very small?

A 1999 study in The Journal of Economic Perspectives by Christina Romer (now head of the Council of Economic Advisers) found that "real macroeconomic indicators have not become dramatically more stable between the pre-World War I and post-World War II eras, and recessions have become only slightly less severe." Ms. Romer also noted that "recessions have not become noticeably shorter" in the era of Big Government. In fact, she found the average length of recessions from 1887 to 1929 was 10.3 months. If the current recession ended in August, then the average postwar recession lasted one month longer — 11.3 months. The longest recession from 1887 to 1929 lasted 16 months. But there have been three recessions since 1973 that lasted at least that long.

The relative brevity of recessions before the New Deal is particularly surprising since the U.S. economy was then dominated by farming and manufacturing — industries far more prone to nasty cyclical surprises than today's service-based economy.

In the late 19th and early 20th centuries, nobody thought the government could or should do anything except stand aside and let the mistakes of business and banking be fixed by those who made them. There were no Keynesian plans to borrow and spend our way out of recessions. And bankers had no Federal Reserve to bail them out until 1913. Yet recessions after the Fed was created soon turned out to be much deeper than before (1920-21, 1929-33, 1937-38) and often more persistent.

It's clear that U.S. history does not support the theory that Big Government means shorter and milder recessions. In reality, recessions always ended without government prodding, long before anyone heard of Keynes and long before the Fed existed. What's more, recessions ended more quickly before the New Deal's push for Big Government than they have in the past three decades. The economy's natural recuperative powers before the 1930s proved superior to recent tinkering by Big Government economists, politicians and central bankers.

The recent experience of other countries provides another way to test the Big Government theory of economic recovery. If it is true that Big Government prevents or cures recessions, then countries where government accounts for the largest share of GDP should have suffered much smaller losses of GDP over the past year than countries where the private sector is dominant.

The chart nearby lists 13 major economies by the size of government spending relative to GDP using OECD figures for 2007 (the U.S. is well above 40% by 2009). Europe's big spenders are at the top, the U.S. and Japan are in the middle, and fiscally frugal countries like China and India are at the bottom.

The last column shows the change in real GDP over the most recent four quarters — ending in the second quarter for the U.S., U.K., Germany, Japan, France, Italy, Sweden and China, but the first for the rest. Four of the five deepest contractions happened in countries with the biggest governments — Sweden, Italy, Germany and the U.K. Japan's government spending in 2007 was about like ours, but Japan's tax rates are far more punitive and the economy has suffered endless "fiscal stimulus" packages. China's central government spent 22% of GDP, but 30%-plus with local government included.

To believe Big Government explains why this extremely long recession was not even longer, we need to find some connection between the size of government and the depth and duration of recessions. There is no such connection in U.S. history, or in recent cyclical experience of other countries.

On the contrary, recessions have become longer as the U.S. government (and the Fed) became larger, more expensive, and more involved in the economy. Foreign countries in which government spending accounts for about half of the economy have also suffered the deepest recessions lately, while economic recovery is well established in countries where government spending is a smaller share of GDP than in the U.S.

In short, bigger government appears to produce only bigger and longer recessions.

It's certainly too early to claim success. About 90 percent of the package hasn't been spent yet. Most of the money that has went to state governments to bail out health and education programs.

The size of the U.S. economy is about $14 trillion. So it would be a specious claim to suggest that the $80 billion spent thus far is fostering the green shoots of an economic turnaround, unless perhaps your idea of economic growth is keeping state bureaucrats employed.

Unfortunately for proponents of government spending as a panacea, there can be no "success" without failure. The reason is simple: the government can't spend money without taxing it out of the economy first, or issuing debt, which begets future taxes. When the government taxes something, the result is less of that something. One of the chief rationales politicians give for raising taxes on cigarettes is that it'll result in less smoking. Why would the result be any different for taxes on economic productivity?

In other words, the government can spend billions of dollars "creating" jobs -- technically a success -- but the cost of those jobs in terms of reduced economic productivity is a failure. And that failure equals lost jobs or jobs not created that otherwise would have been in the absence of the taxes the government needed to "create" those jobs in the first place. Of course, politicians go to great lengths to makes sure the news outlets report on the examples of the jobs they allegedly "create" while conveniently pointing to job losses as a justification for further government spending.

So the question ultimately boils down to this: Is the government or the private sector the best vehicle for creating jobs and fostering economic growth? The previous century seems to have answered that question given that the great centrally planned economies of the period are now resting on the ash heap of history.

As President Barack Obama inadvertently admitted last week, "UPS and FedEx are doing just fine . . . It's the post office that's always having problems."

The Bush administration oversaw one of the most massive increases in federal spending in history. Yet here we are in the midst of the second recession since Bush took office, and a deep one at that. If government spending results in economic growth shouldn't the Bush years have been an economic boom?

The downside of the so-called "stimulus" package is yet to be felt. When all of the bailouts, stimulus and new spending plans are added together, there's a strong possibility the government's deficit for the current fiscal year could hit $2 trillion -- more money than Bill Clinton spent in his last year in office. Thus, in the name of politically expedient short-term "stimulus," future generations of taxpayers are likely to be handed a mountain of debt to finance. Who then will "create" the jobs?

Recently, Sam experienced a big drop in his income, because his employer (the American taxpayer) had been taking financial hits. But Sam likes to live well, so he went to Mr. Goldman and Mr. Sachs' bank and borrowed some money. He also hit up some of his friends in China and Japan for additional loans. Sam had promised to cut back his excessive spending, but then he found he was so good at borrowing he decided not only not to cut back, but to spend more.

Sam was living in a good way. He bought many new cars for his friends and a new health-insurance policy that promised to cover 100 percent of anything his friends might need forever, and Nancy and Harry told Sam he should make his employer pay for it. It was a great life.

But then things began to turn a bit sour. Sam's employer said he would have to take another pay cut to pay for the health insurance and all of the new, legally required environmental equipment, which would wipe out most of the profit he had been making.

Sam then did what he was good at -- he borrowed money. He found out that Mr. Goldman and Mr. Sachs' bank and his Chinese and Japanese friends would still lend him money. But since he had borrowed so much and was a credit risk, they said they were going to have to greatly increase his interest rates. Sam agreed to pay the higher interest in exchange for the additional loans, but then Sam found he did not have enough money for all of the spending he wanted and all the presents he had promised to give to others.

So, as you would expect, Sam ran out of money even sooner this time. He had to run back to the bank and his friends, and borrow even more at ever increasing interest rates, until he found that he was just borrowing more money to pay the interest on all the money he had previously borrowed.

Desperate, he went to see his friend Ben at the really big bank, and said: "What can I do?" Ben looked at Sam's income statements and balance sheet, and said: "You are in deep trouble, but this is what I will do for you. Because there is no way you can now earn enough to pay off all of these debts, I am going to give your employer 'new money' to pay you twice as much as you have been earning." Sam said: "Hey, that's great. But what's the catch?" Ben said: "The money will look the same, but it will only buy half as much as before. It will still be called a dollar so you can pay off your debts to your Chinese and Japanese friends, and to Mr. Goldman and Mr. Sachs' bank. They will all be hopping mad, of course, about getting dollars that can't buy much, but that's their problem."

Sam said: "Wait a minute... I will only be able to buy half the things I used to with these cheap dollars." Ben said: "That's right, Sam, it is called inflation, but it is better than debtors' prison or being knee-capped."

It turns out Mr. Goldman and Mr. Sachs were not at all upset about Sam paying off the loans in "the new dollars" since they had long ago sold off Sam's loans to others who had heard Sam had always been good for the money in the past.

Sam's employer is every American, and we have all been suckered by Nancy, Harry and their irresponsible colleagues. Tax revenues (Sam's income) have been falling at a record rate, and now only cover half of government spending. Spending is up more than 50 percent in one year. Consumer spending rose slightly last month, but incomes fell.

As interest rates rise, as they must, and international commodity and other prices rise as the global economy recovers, real, after-tax, inflation and tax-adjusted disposable incomes will continue to fall. This means real consumption can rise temporarily but will likely fall again, giving the United States a double-dip recession.

Not surprisingly, most of the policy prescriptions advanced by economic pundits and embraced by lawmakers and officials have called on the government to take forceful steps to discipline the free and wild market system that is supposedly responsible for the mess we are in.But a contrarian view that points to the government and its regulatory agencies as prime agents of this economic mess has been promoted by free market-oriented research institutions and magazines.

That is the theme of several articles by economists in the new issue of Critical Review (published by Routledge) as well as in a new Policy Report by the Cato Institute, a Washington-based think tank, that analysed the causes of the crisis.

As suggested by the title for an introductory article written by the Critical Review editor Jeffrey Friedman, a fellow of the Institute for the Advancement of Social Science at Boston University, what we have been confronting was'a crisis of politics, not economics'.

Mr Friedman and other contributors set out to demonstrate that it is not capitalism which has failed - but rather government intrusion into capitalism.

Similarly, Mark Calabria, the director of Financial Regulation Studies at the Cato Institute, challenges in the Policy Report the current narrative in Washington that 'a decades-long unravelling of the regulatory system allowed and encouraged Wall Street to excess, resulting in the current financial crisis'.

Left unchallenged, this narrative will likely form the basis of financial reform measures, he warns, stressing that 'having such measures built on a flawed foundation will only ensure that future financial crises are more frequent and severe'.The financial crisis was caused by 'the complex, constantly growing web of regulations designed to constrain and redirect modern capitalism', Mr Friedman writes in Critical Review. This complexity made investors, bankers and even regulators themselves ignorant of regulations previously promulgated across decades and which interacted with each other to foster the issuance and securitisation of sub-prime mortgages; their rating as AA or AAA; and their concentration on and off the balance sheets of many commercial and investment banks.

It was impossible 'to predict the disastrous outcome of these interacting regulations', he argues.In another article, economics professor John Taylor of Stanford University contends that the financial crisis 'was in large part caused, prolonged, and worsened by a series of government actions and interventions'.

The housing boom and bust that precipitated the crisis were facilitated by extremely loose monetary policy. After the housing boom came to an end, the Federal Reserve misdiagnosed financial markets' uncertainty about the location and value of risky sub-prime mortgage-backed securities as being, instead, a liquidity problem, and 'it took inappropriate compensatory actions that had side effects that included raising the price of oil'. And finally, in mid-September 2008, the government's ad hoc bailouts, and the unpredictable terms of the proposed TARP (Troubled Assets Relief Program) legislation, appear to have caused a sharp spike in uncertainty in the financial markets, Prof Taylor explains.

The contributors to the Cato Institute's Policy Report argue that contrary to the widely held belief that our financial market regulations were 'rolled back', the past few decades have witnessed a significant expansion in the number of financial regulators and regulations.

In a study conducted by the Mercatus Center at George Mason University in Virginia, Veronique de Rugy and Melinda Warren found that outlays for banking and financial regulation increased from only US$190 million in 1960 to US$1.9 billion in 2000 and to more than US$2.3 billion in 2008. Focusing specifically on the Securities and Exchange Commission, the agency at the centre of Wall Street regulation, budget outlays under president George W Bush increased in real terms by more than 76 per cent, from US$357 million to US$629 million.

At the same time, Mr Calabria disputes the claim that deregulation, and in particular the Gramm-Leach-Bliley Act, the core of which was the repeal of the New Deal-era Glass-Steagall Act's prohibition on the mixing of investment and commercial banking, caused the crisis by clearing the way for investment and commercial banks to merge, and thus giving investment banks the incentive to take greater risks, while reducing the amount of equity they are required to hold against any given dollar of assets.

But Mr Calabria notes that even before the passage of the Act, investment banks were already allowed to trade and hold the very financial assets at the centre of the financial crisis, such as mortgage-backed securities, derivatives, credit-default swaps and collateralised debt obligations. And secondly, very few financial holding companies decided to combine investment and commercial banking activities. The two investment banks whose failures have come to symbolise the financial crisis, Bear Stearns and Lehman Brothers, were not affiliated with any depository institutions. In fact, as Mr Calabria suggests, 'had either Bear or Lehman possessed a large source of insured deposits, they would likely have survived their short-term liquidity problems'.

And he refers to an interview that former US president Bill Clinton had given to BusinessWeek in 2008, in which he contended that signing the Gramm-Leach-Bliley Act had nothing to do with the current crisis.

'Indeed, one of the things that has helped stabilise the current situation as much as it has is the purchase of Merrill Lynch by Bank of America, which was much smoother than it would have been if I hadn't signed that bill,' Mr Clinton said. According to Mr Friedman, the financial crisis demonstrated that market participants - very much like government regulators - tend of make cognitive rather than 'incentives-based' errors, challenging the case for government regulations and calling into question 'the feasibility of the century-old attempt to create a hybrid capitalism in which regulations are supposed to remedy economic problems as they arise'.

Indeed, as Mr Friedman concludes: What may have saved the world from complete economic chaos in 2008 was the fact that the regulations were loose enough that many investors and many bankers had resisted buying the 'safe' securities that most banks seem to have bought.

As China's foreign exchange reserves passed $2 trillion, its calls for a new international monetary system are becoming more strident. Is there a case for changing the current floating rate international monetary 'non-system' with the dollar as its core?

Any international monetary system faces the 'trilateral dilemma'. One can have two, but not all three, among fixed exchange rates, monetary independence and free international mobility of capital. Under the Gold Standard (which perished in the Great Depression) there were fixed exchange rates and free capital mobility but no monetary independence. Under the Bretton Woods quasi-fixed exchange rate system which replaced it (and perished in the Great Inflation generated by the Vietnam War), there were fixed exchange rates and monetary independence but not free capital mobility, with capital controls restricting short-term capital movements. In the current floating rate 'non-system' there is capital mobility and monetary independence but no fixed exchange rates.

The Chinese, who have run a Bretton Woods-type quasi-fixed exchange rate system — with an undervalued renminbi pegged to the dollar — want to extend it to the world, with an expanded form of SDRs replacing the dollar as the global reserve currency. This desire is based on China's reluctance to freely float its currency, and its mounting fear that US fiscal and monetary expansion will lead to a fall in the value of its massive holdings of US government debt, as US interest rates rise and the dollar depreciates. This is a consequence of its foolish exchange rate policies, which in effect have converted a large part of China's massive savings into relatively low-yielding US government debt. But, should the world accede to the former Chinese desire (as also that of Russia and Brazil) to dethrone the dollar, and is it likely to succeed?

Any quasi-exchange rate system is subject to a fundamental flaw. It depends upon control of short-term capital movements, which could lead to speculative attacks on the currency. But, these controls become increasingly leaky as foreign trade is liberalised, as short-term capital can be moved through the 'leads and lags' in foreign trade: with exporters 'under-invoicing' exports, and importers 'over-invoicing' imports, keeping the difference in whatever foreign currency they choose.

Despite draconian capital control, China has not been able to control such 'hot money' flows. Its latest increase in reserves of $178 billion (in the second quarter of 2009) is not based on the traditional drivers of the trade surplus and foreign direct investment which, at about $60 billion, were the lowest in three years. The increase was due to 'hot money' inflows of between $30 billion and $70 billion ("Lex", FT, July 15). To prevent any currency appreciation, the Chinese have (as in the past) sterilised these inflows. But with the domestic money supply, nevertheless, rising rapidly with the growing credit made available to stem the slide in output caused by the global financial crisis, a serious housing and stock market bubble is developing. With non-traded goods prices rising, whilst those of traded goods are kept constant through the relatively fixed nominal exchange rate, the real exchange rate must be appreciating. China, because of its continuing attachment to the Bretton Woods Mark II system, is likely to find its current distorted recovery unsustainable. Why then should the rest of the world follow it by embracing another Bretton Woods type system for the international monetary system?

China's desire for an enhanced SDR (with the BRIC currencies having a greater weight) is also likely to be unfulfilled. Central banks have had the opportunity to diversify their reserves into non-dollar assets, including SDRs, but have not chosen to do so. Instead, dollar holdings in central bank reserves have risen to about 75 per cent of total reserves in the first quarter of 2009. Nor is the Chinese move to finance its growing bilateral trade with emerging markets in renminbi likely to make its inconvertible currency a potential reserve currency. It is more like the creation of a 'rouble area' under Comecon.

Nor is the proposal being floated by a Brazilian economist for four competing currency unions, with four alternative reserve currencies, likely to succeed. Ricardo Amaral ("Brazil, China, and the New Asian currency", www.rgemonitor.com) has proposed an Asian currency union (modelled on the euro) centred around the renminbi, which would also include Brazil. Russia should join the euro, and the Gulf countries should have a common currency centred on the Saudi rial. But, currency unions require some political common ground amongst the participating countries ideally, as in the US— currency union is a political union. The euro still remains fragile, because the hoped-for European political union has not yet emerged. A stable political union is necessary if 30-year bonds issued in the common currency are to be widely held. Without a political union there can be no guarantee that the common currency will be around when the bonds come to be redeemed.

Though a Gulf currency union with a political union seems more feasible, there is no chance of an Asian currency union comprising, I presume, India, Japan and the southeast Asian countries with such divergent polities being formed. Who would be willing to hold the bonds of an authoritarian country whose currency remains inconvertible for its citizens and foreign holders?

Finally, though the dollar may be in trouble, it remains the currency of the sole superpower. The sterling remained the world reserve currency even after British hegemony was beginning to slip. So, I do not expect the dollar to cease to be the world's reserve currency for a long time to come. The current international monetary 'non-system' remains the only desirable one to deal with the continuing turmoil in the world economy.