The US Treasury Department says that bailouts add risk to the financial system.

WASHINGTON - The government's response to the financial meltdown has made it more likely the United States will face a deeper crisis in the future, an independent watchdog at the Treasury Department warned.

The problems that led to the last crisis have not yet been addressed, and in some cases have grown worse, says Neil Barofsky, the special inspector general for the trouble asset relief program, or TARP. The quarterly report to Congress was released Sunday.

"Even if TARP saved our financial system from driving off a cliff back in 2008, absent meaningful reform, we are still driving on the same winding mountain road, but this time in a faster car," Barofsky wrote.

From a November 2009 report we get the word that more stimulus creates more unemployment.

"Stimulus" is in the process of turning a nasty recession into a genuine depression. The evidence is in the "Employment Situation" report released by the Bureau of Labor Statistics (BLS) on November 6th. The "headline" unemployment rate shot up to 10.2%, the highest in more than 26 years. But the report was much worse than most people realize.

The "household survey data" showed that 589,000 jobs vanished during October. This is bad enough, but the three-month moving average of changes in total employment (current month and prior two months) shows that job losses are actually accelerating.

The three-month moving average (TMMA) of changes in total employment began a serious decline in February 2007. It went into negative territory two months later. This indicator has now been negative for the past 21 months. During this time, total employment has declined by more than 8 million jobs.

The massive sales of U.S. Treasury bonds to finance "stimulus", bailouts, and other government spending is sucking capital out of the private sector and destroying jobs.

The smaller banks are carrying the burden of the commercial real estate problems and consumer debt and mortgages still present these banks with problems because these loans represented "Main Street" and were not all packaged and sold to investors in Finland. Remember there are 552 banks, all small- and medium-sized banks that are on the FDICs list of problem banks and this is expected to grow this year before declining, generally do to actual failures.

There are more dislocations throughout the economy that point to persisting problems. For example, in manufacturing, since the 1960s the unused capacity of United States industry has continually declined from peak usage to peak usage of that capacity The latest peak utilization of capacity still saw that about 20% of the industrial capacity of the United States remained unused. Unused capacity for the past thirty years seems to average around 23% to 24%.

We see unused capacity in the labor force as well. Since the 1970s under-employment of labor has grown quite consistently. Attention is focused upon the unemployment rate, but this measure does not include those individuals that have left the labor force because they are discouraged and those that are only working part time but would like to work more. We have seen estimates that 17% to 20% of the employable people in the United States are under-employed. Another dislocation that is not comforting.

Then we hear about the problems in state and local governments. Reports indicate that there are more than 30 states that are currently experiencing fiscal difficulties. We hear most about California and New York, but there are many other states particularly in the west and southwest that are having real problems. One estimate is that the states will have a combined budget shortfall of at least $350 billion in the fiscal years of 2010 and 2011. And, this doesn't even get to the difficulties that are being faced by local governmental bodies.

And, there are the dislocations being created by the federal government. Budget deficits for the next ten years have been placed in the range of $15 trillion. The United States is fighting three wars throughout the world. The government is passing health care legislation that has been justified fiscally by postponing start dates of programs from three to five years. There is climate control efforts being considered along with regulations, like anti-pollution controls, that will just exacerbate the economic and fiscal problems of the country. Then there are other changes in the rules and regulations that apply to industry that will further change the playing field and create greater uncertainty about what management's should do.

There is the problem of unemployment, the number one issue among the American voter. (And you thought the number one issue was health care or pollution or terrorism or the war in Afghanistan.) But, there is a dislocation problem relating to federal government stimulus programs.

For fifty years or so the federal government has attempted to stimulate the economy to put people back to work in the same jobs from which they were released from. The government has sought to put unemployed people back to work in the steel industry, in the auto industry and in other jobs that are the backbone of American industry (according to the labor unions and others). As a consequence, the steel industry lost competitiveness, the auto industry lost competitiveness and so did many other industries.

This effort to stimulate the economy and put people back into the jobs that they lost has contributed greatly to the increase in the unused industrial capacity and to the increase in the under-employed in this country. The effort to constantly maintain a low unemployment rate by putting people back into the jobs they have lost has resulted in a massive slide in the competitive position of the United States.

...the news about the manufacturing sector gets a little better. According to the Federal Reserve, the dollar value of U.S. manufacturing output in November was $2.72 trillion (in 2000 dollars), which translates to $234,220 of manufacturing output for each of that sector's 11.6 million workers, setting an all-time record high for U.S. manufacturing output per worker (see chart below). Workers today produce twice as much manufacturing output as their counterparts did in the early 1990s, and three times as much as in the early 1980s, thanks to innovation and advances in technology that have made today's workers the most productive in history. So at the same time that manufacturing employment has been declining to record low levels, manufacturing output keeps increasing over time, and the amount of output that each manufacturing worker produces keeps rising almost every month to new record high levels.

Which brings me to a book. This Time is Different: Eight Centuries of Financial Folly and a book review.

Unemployment rose by several hundred thousand jobs in the fourth quarter, and if you look at some surveys, it approached 500,000. That is hardly consistent with a 5.7% growth rate. Further, sales taxes and income-tax receipts are still falling. As I said last year that it would be, this is a Statistical Recovery. When unemployment is rising, it is hard to talk of real recovery. Without the stimulus in the latter half of the year, growth would be much slower.

So should we, as Paul Krugman suggests, spend another trillion in stimulus if it helps growth? No, because, as I have written for a very long time, and will focus on in future weeks, increased deficits and rising debt-to-GDP is a long-term losing proposition. It simply puts off what will be a reckoning that will be even worse, with yet higher debt levels. You cannot borrow your way out of a debt crisis.

While I was in Europe, and flying back, I had the great pleasure of reading This Time is Different, by Carmen M. Reinhart and Kenneth Rogoff,...

Let's lead off with a few quotes from This Time is Different, and then I'll add some comments. Today I'll focus on the theme of confidence, which runs throughout the entire book.

"But highly leveraged economies, particularly those in which continual rollover of short-term debt is sustained only by confidence in relatively illiquid underlying assets, seldom survive forever, particularly if leverage continues to grow unchecked."

"If there is one common theme to the vast range of crises we consider in this book, it is that excessive debt accumulation, whether it be by the government, banks, corporations, or consumers, often poses greater systemic risks than it seems during a boom. Infusions of cash can make a government look like it is providing greater growth to its economy than it really is. Private sector borrowing binges can inflate housing and stock prices far beyond their long-run sustainable levels, and make banks seem more stable and profitable than they really are. Such large-scale debt buildups pose risks because they make an economy vulnerable to crises of confidence, particularly when debt is short term and needs to be constantly refinanced. Debt-fueled booms all too often provide false affirmation of a government's policies, a financial institution's ability to make outsized profits, or a country's standard of living. Most of these booms end badly. Of course, debt instruments are crucial to all economies, ancient and modern, but balancing the risk and opportunities of debt is always a challenge, a challenge policy makers, investors, and ordinary citizens must never forget."

One point I found fascinating, and we'll explore it in later weeks. First, when it comes to the various types of crises with the authors identify, there is very little difference between developed and emerging-market countries, especially as to the fallout. It seems that the developed world has no corner on special wisdom that would allow crises to be avoided, or allow them to be recovered from more quickly. In fact, because of their overconfidence - because they actually feel they have superior systems - developed countries can dig deeper holes for themselves than emerging markets.

Oh, and the Fed should have seen this crisis coming. The authors point to some very clear precursors to debt crises.

So what should the US Government do? Other than keep people off the streets - nothing. And by off the streets I don't mean in homes that are unaffordable. A roof - we have plenty of them - and a minimal diet. Then let the wisdom of 300 million people take over.

At the core of our problem is a secular decline. The easy gains from microprocessors (I have the equivalent of four or ten Cray 1s on my desk - not so micro any more. Except for size.) have been realized. So what is the next big thing? It could be a real breakthrough in fusion not one of those mega projects with big promises and small results. It might be in carbon nanotubes. Or it might be a breakthrough in materials that allows us to substitute cheap materials for much more expensive ones. Or it could be something in biotech. Or a new way to do business. Or probably something hardly any one knows about. Some unrealized potential.

The deal is, that what ever it is, Washington with its macro policies is more likely to hurt than help. So what could Washington do? Pour money (it need not be a lot) into micro policies. More fundamental research. And a big push into research is not expensive. A few tens of billions a year could reap us big dividends. If we are truly in a knowledge economy (we are) then what we need is more knowledge not more bail outs of dying sectors of the economy. What is unseen is more important than what is seen.

H/T Instapundit

Cross Posted at Power and Control