The cause most commonly suggested is public anger at the political arrogance of the Democratic leadership, together with the political class’ indifference to the economic plight of the citizenry.

Without criticizing any of the explanations provided now or in the future, it is our belief that something even more fundamental is at work here, which might well make the 2010 campaign a historical turning point. That basic factor is the breakdown of longstanding political ideologies.

“Longstanding” is chosen deliberately, for we are talking about capitalism and socialism.

Both of these are usually seen as purely economic models, but in fact they are complete thought systems aimed at organizing all social activity. They lie at polar opposites to each other, one emphasizing the power of the state, the other the supremacy of the individual.

It is interesting to note that free enterprise and state authority were never, prior to the advent of the Industrial Revolution, considered to be fundamentally inimical to each other. Both were deemed necessary to the conduct of human affairs, and a balance between the two was always considered the best guarantee of material prosperity and political stability.

The Industrial Revolution ended this traditional compromise. The huge increase in material production and wealth, itself made possible by the use of fossil fuels, was thought to require a new approach. Who would benefit from this unprecedented cornucopia became a philosophical question that would influence political thought and economic principle for the following two centuries.

On the one side was the capitalist theory, which claimed that if the creators of the new industrial economy were left alone to work their entrepreneurial magic, maximum prosperity would follow, profiting everyone and guaranteeing continuous progress. The state should step aside and reduce its role to supporting capitalist creativity and allowing free reign to market forces.

Opponents pointed to social inequality and economic exploitation in order to discredit the above view. They claimed that the new prosperity was the fruit of everyone’s labor and should be shared equally. This demanded an increase of the power of the state, which would become the supreme arbiter of material development and of the fair distribution of the wealth produced.

The conflict between these two ideologies occupied most of the 20^th century, with its revolutions and wars. By the end of 1900’sit had become clear that both systems had inescapable flaws.

Capitalism was indeed immensely dynamic, but its development proceeded in a succession of booms and busts. Booms enriched primarily the upper classes, while the brunt of busts was born by the lower income population. The unwanted but very real consequence was a trend towards economic inequality and social conflict.

Socialism had matching flaws. While the state managed to distribute wealth more or less equally, there was not much to distribute, due to the inertia and inefficiency of the state-run socialist economy. In addition the socialist system showed a disturbing tendency to turn into a police state.

To avoid the most glaring shortcomings of each, the two systems were over time blended into hybrids. These constructs, however, lost the advantages of both concepts while magnifying their defects: they were neither efficient nor fair, neither stable nor dynamic.

Instead what appeared was the unwholesome combination of an unaffordable, unmanageable government with highly concentrated economic oligopolies: inequality with inefficiency, economic exploitation with bureaucratic arrogance.

This combination is exactly what, according to many commentators and analysts, the Massachusetts voters were angry about. They also happened to have an early election to voice their frustration. The rest of the country is not far behind, some nine months to be precise.

Neither the political class nor the economic elite, now locked into an embrace of mutual preservation, can deal with the situation. Policies outside the old progressive and conservative frameworks are required: solutions that actually solve problems, plans that can be implemented, sound-bites that catch the reality of our situation.

Anything else will bring out more “torches and pitchforks”, town hall meetings and tea parties

This is the year of the awakened voter. It is likely to be, just as well, the beginning of the end for the old Right and Left. Failed theories must, from now on, be replaced with practical leadership.

Mr. Kay is the first commentator (to our limited knowledge at least) to connect the last three major crises (the 1997 Asian bust, the dotcom crash and the current Great Recession) to a common denominator. In addition he squarely points to the current globalized financial system as the common cause of these three events.

He also points out that each downturn has been more severe than the preceding one, indicating an escalation in size and intensity. The current recession has “maxed out” the capacity of central banks and governments to deal with the situation. The next one will be worse and possibly beyond anyone’s control.

We regret that the author did not, in our opinion, define more clearly the underlying causes of this sequence of booms and busts. These, as we see, are as follows:

The first cause is the creation, through unrestrained trade and budget deficits, of a large unanchored monetary mass beyond the control of any government or international institution. Because the U.S. is the primary provider, this mass consists mostly of dollars exported from America to finance U.S. private consumption and government spending.

The second cause lies in the globalization of finance and the removal of nearly all previously existing controls on currency and capital flows. This allows the large monetary mass mentioned above to move relatively freely around the globe in pursuit of the best returns, concentrating wherever such opportunity arises.

These capital flows are now so large that they overwhelm the ability of even the richest states to react and bring about the necessary corrections. As long as financial globalization remains an article of faith, neither governments nor international organizations will be able to prevent another financial tsunami.

As Mr. Kay points out, governments barely contained the devastation caused by the latest wave. However, they have done so not by starving and weakening the “financial beast”, but by feeding it additional mountains of money through bail-outs and deficit spending, all under the cover of financing a “recovery”.

Such a recovery is posited by Keynesian theory, according to which government spending replaces private outlays during an economic downturn. This has, in the past, worked to a degree. But we are not living in the past. The present is different.

Keynesian theory was created during the Great Depression, when the bulk of national economic activity took place within national borders. In addition, capital flows and exchange rates were controlled by regulation, and trade was limited by tariffs. Under such constraints government spending would remain concentrated within the national economy.

This is no longer the case. Current government outlays are funneled through a transnational system, within which money flows wherever the returns are highest and speculative activities most profitable. In addition, the expansion of the welfare state guarantees that a large portion of government spending goes to cash transfers, which, while maintaining a subsistence level of economic activity, result in no productive investment.

The amount of stimulus spending needed to generate a “recovery” is therefore far greater than what would have been considered adequate during the 1930’s, which have provided the model for current policies. In the meantime a large portion of the money leaks out and increases the loose global monetary mass, guaranteeing that the next boom-and bust cycle will be more intense than the last one.

This is a situation for which there is no historical precedent, because such conditions have never existed until today. As Mr. Kay writes, we have created a “monster”. In fantasy stories, monsters are feared and eventually destroyed. We are feeding ours instead, making it bigger and stronger.

Our current policies thus lead directly to another crisis, worse than the current one.

The remaining ray of hope is that the “recovery” will prove so weak and unstable (which is likely) that political pressure will require to abandon present policies in favor of more effective measures. The upcoming U.S. congressional elections may turn out to be a test case in this area.

“Greedy bankers” make convenient whipping boys, but if banks are making profits again, why should their executives not get paid accordingly? Every other industry rewards its winners. On the other hand, if bankers are guilty and need to be punished, it behooves us to first determine what they did wrong.

As was found out once the current crisis hit, banks had invested large amounts of money in questionable assets. When these assets turned out to be less valuable than originally assumed, the financial system faced worldwide bankruptcy, from which it was saved by huge, and still continuing, provisions of government money.

The key question to be asked is why so many dubious assets were created and purchased in the first place.

The iron rule of economics is the law of supply and demand. Greed plays a part as well, but the supply and demand rule underlies everything else.

The assets in question were created and sold because there was demand, meaning money looking for assets to invest in. If there was more money than available assets, new ones had to be created to satisfy the demand, and created they were, sometimes out of thin air. This asset creation fed a speculative bubble. When the bubble popped, the system crashed.

So the initial problem was not the dubious assets, but the excessive abundance and availability of money. Funds were abundant because interest rates were low, but also because the U.S. government had pumped the global financial system full of dollars through large and continuous budget and trade deficits. This mass of money then was freely available because the financial system was globalized, and funds could move around in huge amounts, seeking the best returns.

Finding solid investment opportunities is hard work, and returns are often slow to materialize. Creating phony assets is easy and brings an immediate financial reward. A financial system loaded with piles of freely moving money is an open invitation to speculate. In the short run, speculation generates more profit than sound investment. As it stands now, the financial system is structured to maximize both speculation and greed, while short-changing valid investment.

Bankers and traders may be greedy, but the system set-up encourages them to be.

The last fifteen years have seen financial crises of increasing gravity: the Asian crisis, the Russian default, the dotcom bust and the 2007-2008 crash. All flow from the dynamic outlined above: too much money moving too freely and too fast.

This situation has now been aggravated by the “remedial” measures taken by governments and central banks to mitigate the current crisis. These measures translate into increased deficits and the wholesale printing of money, and have vastly increased the monetary mass in the global system.

The logical consequence of this would be the formation of more speculative bubbles, followed by new crashes. It is questionable, however, whether any asset category can by now absorb even a fraction of the money in circulation, old and/or newly created. This is all the more true as the “real” economy is weak and has little inherent dynamism aside from government stimuli. If the floating monetary mass then remains unabsorbed, the probable outcome will be a monetary collapse, led by an imploding dollar.

The consequences of this are hard to imagine. There is no precedent for a global monetary crash. Yet this is where we are, in all probability, heading if current policies are maintained.

The above “if” suggests an alternative approach. Such a shift is not ruled out because the U.S., the country at the core of the issue, is heading for a crucial election, the stakes of which are extremely high.

Alternative policies could therefore be embraced by a political challenger to the status quo. These policies would include:

-          Budgetary tightening aimed at the elimination of fiscal deficits

-          Measures to promote investment in the real economy

-          Tariffs applied to major trade imbalances

-          Taxation of speculative activities within the financial system

There is no guarantee that these measures will produce a smooth transition to a more viable system. Any induced shocks will nevertheless be much easier to handle than a wholesale monetary collapse.

We have a choice between a deteriorating status quo and a new start. This choice must be clearly articulated as we move towards the 2010 elections.

In the 18^th century this right was gradually transferred to the people as a whole. Under a democratic government, national sovereignty is the implied right, shared by all citizens, to order their life as they please without outside interference.

Sovereignty has always been looked upon as a political concept. At the time the U.S. Constitution was written, economic sovereignty was a given. The overwhelming majority of goods used for daily life were produced locally, usually within the immediate vicinity. Only a small portion came from outside the national territory, and those were mostly luxury products that the majority of the population had no use for.

In an agrarian economy everything needed for physical existence is under the population’s de facto control. This gradually changed as the Industrial Revolution took hold. As the standard of living rose, a greater proportion of the goods needed to maintain life and prosperity came from distant locales, where industrial facilities were concentrated.

Who controlled these facilities gradually became a major issue. The struggle between capitalism and socialism was over the “control of the means of production”, and brought to the fore the people’s right to control the basis of their material existence.

Until the middle of the 20^th century, however, the bulk of such goods were produced within the national territory. The energy “oil shocks” of the 1970’s were the first public sign that this was no longer the case. At least some of the “necessities of life” were now coming from outside the national territory.

The globalization of the oil market was followed by a similar evolution in many other fields. The U.S. today is deeply enmeshed in trade networks spanning the entire planet, and a host of vital supplies, ranging from drugs to clothing to fertilizer, are no longer produced domestically. Two major justifications are offered for this process of increasing dependence on foreign supply sources.

The first is the lower cost obtained by going to the cheapest supplier, wherever he may be. Global markets are said to be more efficient, providing the greatest amount of goods at the lowest expense.

The second justification is that this evolution represents “progress”, that it is the next phase in the general development of mankind, and is therefore by definition both beneficial and inevitable.

That the development of mankind is linear and irreversible is of course an unproven assumption. That this particular manifestation of it, namely economic globalization, is entirely beneficial is also debatable.

In a democracy, the citizenry controls the government, at least in theory. Foreign suppliers of goods to U.S. citizens are controlled by their respective governments, be they democratic or not. They are the suppliers, and to that extent they control us. We, as their market, have some control over them. But each side is also dependent on the other, implying in the end a loss of freedom and sovereignty.

This loss is amplified by the fact that the terms of trade and exchange are usually set by persons and organizations with no formal responsibility towards the citizenry: multinational corporation executives, international institutions, and the managers of the globalized financial system. All these persons and entities pursue their own interests and are not bound by a popularly approved charter such as the U.S. Constitution.

The question of whether the citizenry approves or disapproves of this state of affairs has never been mooted, even though the populace has to bear the consequences, as in the course of the current crisis.

The essence of democracy is that the people should control the circumstances of their own life, be they political or economic. In the United States, at this time, they do not, in the economic sphere, have such control. While political sovereignty still stands, its economic counterpart is eroding away.

This issue is as vital as the causes of the revolutions of the 18^th and 19^th centuries. It will lead to similar upheavals if it is not addressed.

Now our purpose here is not to dismiss the climate change issue, which is a serious one, but to question the rush to take action, any action. While the accumulation of greenhouse gas in the atmosphere certainly has an impact, the global warming hypothesis is still just that: a hypothesis.

No one has proved global warming in terms of demonstrating that if A (greenhouse gas accumulation) occurs to such and such a degree, then B (a specified rise in global temperature) will take place within a given time span. Such proof of causality is the hallmark of any accepted scientific theory. Until it can be done, global warming remains a working hypothesis, though a plausible one.

The recent controversy over hacked e-mails supports the above. The fact that a key group of scientists feel a need to silence opponents and manipulate data clearly shows that the politics of the issue have gotten ahead of the state of scientific knowledge; in other words, that critical components of the greenhouse gas theory are still in doubt.

Besides, there are other plays in town.

Greenhouse gas accumulation is only one of several factors acting on the climate. Two others at least merit special attention.

Of these, orbital variations are the best documented. Such variations in the earth’s orbit and axis inclination have been correlated with ice ages, and according to one theory at least the earth is due for a significant cooling period, possibly a new ice age.

The other variable is the sunspot cycle. Normally sunspots wax and wane over an 11-year cycle, but at times, for reasons we do not know, the cycle weakens or even shuts down. The last such episode, which lasted from 1645 to 1715, is known as the Maunder Minimum or the Little Ice Age.

This should not overly concern us, except that the last solar cycle had an unusually long tail, much longer than normal. The sunspot count has been near zero for a couple of years. There is some indication that the cycle is restarting, but the trend will not be clear for two or three years.  Current projections for the next cycle make it the weakest in nearly a century.

Sunspots generate solar storms, sending charged particles towards the earth. These warm the atmosphere when they hit. In the absence of solar storms our atmosphere cools and contracts. If the cycle weakens over the coming years, or decades, the atmosphere will tend to cool.

Objective research on all the above, as well as other factors affecting global climate, is urgently needed. The funds spent on such research will be far less than the cost of various schemes aimed at reducing greenhouse gas accumulation, commonly known under the designation Cap and Trade.

The Cap part is a tax on carbon dioxide emissions, aimed at limiting the use of fossil fuels. Since roughly 90% of our energy comes from this source, it amounts to a tax on energy. Such a tax will be highly regressive, hitting the lower-income part of the population the hardest.

The Trade components allows energy producers to buy and sell carbon emission permits, which amounts to a new public subsidy for the financial sector, through which such transactions will be performed. In summary, the scheme will result in a transfer of wealth from the poor to the already rich.

This is objectionable to begin with, but there is another fundamental reason why the implementation of such schemes should be postponed.

As outlined above, a number of separate factors influence climate, and we know little concerning their respective impacts and their interactions. To date the climate debate has focused almost exclusively on greenhouse gas emissions, without regard to how this factor fits in the wider scheme of things. What if we implement a burdensome cap and trade program only to find out, a few years down the line, that it was unnecessary or even counterproductive?

A more prudent and effective approach would be to abandon the current growth-by-any-means paradigm in favor of a national program aimed at energy efficiency and the long-term development of a sustainable energy supply. This would reduce carbon emissions by a much larger amount the current tax-based schemes.

It would also be a boost for economic activity, domestic investment and technological innovation, all of which are urgently needed.

The recession started as a financial crisis that transferred to the real economy, in the process generating massive unemployment. As the downturn became more severe unprecedented measures were taken to stop and reverse the downward slide.

These measures were inspired by the analysis of the Great Depression. The main conclusion reached by the Federal Reserve was that in the 1930’s the government had not provided sufficient liquidity to the banking system. Had this been done, the reasoning went, financial activity would have returned to normal, providing enough credit for economic growth to resume.  

The prescribed cure for the current crisis was thus to insure that abundant liquidity was provided to the banking system. This was done through the printing of money, zero interest rates coupled with deficit spending, and a variety of programs and devices that provided abundant and cheap funding to the financial sector.

The expected result of these measures was to be a rise in the availability of credit, which in turn would lead to increased borrowing, spending, investment and other business activity.

To-date this has not happened. While the financial sector is awash in money, credit to the general economy has in fact significantly contracted. Except when temporary government subsidies have been available, economic activity is still at a very low level, with no sign of a significant improvement.

The above analysis of the Great Depression might have been correct as far as the nineteen thirties went, but in applying it to current circumstances a critical point was overlooked. Whereas the 1929 economy was national, the present one is integrated within a globalized financial system.

The key characteristic of this system is that capital can freely and instantaneously circulate around the globe. Under such conditions it will naturally move to where it will generate the highest return. U.S. authorities have injected trillions into the system, on the presumption that these funds would be mainly put to work in the United States, as they would have been in the thirties.

Conditions in the U.S., however, are not favorable to high returns on capital: interest rates are near zero, the economy is depressed, and growth is sluggish at best. Assets offering far better returns, be they foreign stocks, commodities, or currencies, are to be found all over the planet. That is where the money naturally flows.

The immense funds disbursed by the U.S. government and central bank have essentially leaked out of the country, leaving the national economy struggling, unemployment at high levels and prospects poor. But that is not all. Another pernicious effect is building up.

Budget and trade deficits, liquidity enhancements and the massive creation of money depreciate the currency, while all assets offering the best returns inevitably rise in value. Because of the sheer size of the U.S. economy and monetary mass, the outward flow of money generates dollar inflation wherever it finds something to acquire.

If the U.S. economy were strictly national, the wholesale increase in liquidity would produce internal inflation. The global financial system sees to it that this inflation instead occurs wherever our dollars end up: in foreign stock markets and property values, for instance, or in the dollar price of commodities such as oil and metals.

Since the U.S. imports far more than it exports, this outside inflation will eventually be imported as well. As the dollar depreciates and imports rise in price, domestic consumption will be choked off just at the time it begins to grow again. The U.S. consumer, being and feeling poorer, will further reduce spending, and the economy will remain stalled.

The entire anti-recession effort would have been for nothing. In fact that very effort will have ensured that the recession will continue into the foreseeable future. The only tangible results will be a much higher national debt, a devalued currency, and a financial industry even more addicted to short-term speculation.

What the country needs to recover is a strong emphasis on domestic investment, which alone will create employment. This is perfectly attainable, but requires a radical departure from the current policies.    

A similar situation is developing in the economic arena.

As the current recession started in 2007, government policy under President Bush focused on rescuing the failing financial sector. The Obama administration picked up and amplified that policy. Several trillions in taxpayer money have now been spent by the Treasury and the Federal Reserve to bail out banks and other financial entities.

The sums spent to prop up U.S. finance dwarfed those dedicated to the real economy. The main priority has been, and still is, to keep the globalized financial system from crashing and to set it back on its feet.

This policy ignored or fudged the fact that global finance had collapsed through its own imbalances and excesses. Thus restoring the status quo ante provides no guarantee of stability. On the contrary, it reinforces and extends the risk of a relapse into crisis.

The globalization of finance has been a major tenet of U.S. economic policy for three decades. Safeguards erected against a coordinated global crash, such as the Glass-Steagall Act, have gradually been removed. Controls over capital movements and exchange rates are gone as well, eliminating all restraints on world monetary flows.

At the same time, U.S. fiscal and trade deficits have vastly increased the amount of money in circulation. This floating, unanchored and anonymous mass of money moves freely around the globe, seeking the highest returns. In the process it generates massive financial bubbles, as no asset class is large enough to absorb it.

Globalized finance has generated the Asian crisis, the dot.com bust, the U.S. mortgage disaster, and the 2008 spike in commodity prices, including oil at $148 a barrel. The latest ongoing episode is the current stock market bubble, fed and amplified by massive government cash injections and ultra-low interest rates.

The economic impact of this situation is, first, a shift from productive to speculative investment, with a bloated financial sector and a shrinking real economy; second, a series of economic dislocations caused by the boom and bust cycle, with the burden falling on the majority of the working population.

With the U.S. unemployment rate now at 10.2 percent, with another 8 percent or so under-employed, the justifications for propping up the financial sector ring increasingly hollow.

The trillions of dollars disbursed by the Federal Reserve and Treasury were meant to support bank lending capacity and restore the credit available to the real economy. Instead lending has been curtailed everywhere and the economy is flat on its back while Wall Street is looking at a banner year.

The stock market has shrugged off the rising U.S. unemployment numbers, and for good reason. With a global sandbox to play in, U.S. taxpayer money, provided at zero interest, can be much more profitably invested in Hong-Kong real estate, Brazilian stocks, or oil and copper futures than in struggling American businesses.

In other words, as long as Uncle Sam keeps shoveling money at the banks, the financial sector does not need the rest of America. The government so far appears to agree.

From the political viewpoint, as Ms. Strassel points out, the administration policy has been a disappointment. From the economic angle, it depends from who profits. For the financial industry, it is a godsend. But for the general population it is a resounding failure.

It remains now to be seen how long the stock market bubble can keep inflating when there is no economy supporting it, the government is broke, the central bank is printing money and the currency is losing value.

A realistic answer could be phrased as follows: current policy will probably be maintained for a while, but in the end it does not matter all that much.

The cheap money and stimulus exertions of the current administration have had some effect in goosing up the economy, and will probably continue to support it to some degree. How much and how long is a moot point, because whatever recovery eventually occurs will be drowned in a tsunami of taxes.

This new flood of taxation will inevitably be generated by the legislative initiatives now in the works: cap and trade legislation, national health care and unrestrained deficit spending.

Let us look at each in turn.

The cap and trade legislation is a tax on the carbon emissions resulting from the use of fossil fuels. Since fossil fuels at this time provide close to 90% of U.S. energy consumption, it is equivalent to a tax on energy. As agriculture is a major energy user, it will also translate into a tax on food.

Cap and trade, in other words, will institutionalize the food and energy price spike that occurred in 2008. As a tax it will also be highly regressive, hitting the lower income segment of the population the hardest. For both reasons it will kill consumption, which accounts seventy percent of the Gross Domestic Product, making the recession permanent.

This effect will be immediate because once the legislation becomes law both energy suppliers and energy users will have to initiate the necessary adjustments immediately, so as to be ready when the program is actually implemented. Energy prices will rise to pay for the required investments and/or financial penalties.

The same will occur once the proposed health care reform becomes law. While the system may not be implemented for several years, the taxes to support it will take effect immediately. These levies will hit businesses the hardest, in particular the small businesses which are responsible for a large percentage of employment.

Owners will reduce the number of employees to the minimum, letting workers go instead of hiring and dashing any hopes of seeing current unemployment numbers go down.

Thus the main programs now being worked on in Congress will result in new taxes specifically targeting consumption and employment. To these will then be added a miscellaneous burden of taxation needed to cover the deficits currently projected into the indefinite future. Already programmed is the expiration of the Bush tax cuts, but that will not be nearly enough. More will certainly be added, possibly some version of the Value Added Tax that has already been mentioned.

The impact of the above on the economy and individual well-being will be severe.

One might consider such a scenario overly pessimistic, but it is only a linear extrapolation of policies and programs the current administration and congress appear determined to implement.

There are two main reasons why they could fail. One is a breakdown of communications and discipline within the reigning Democrat party, a failure of will in the face of the obvious consequences of their legislative goals.

The other is a wholesale taxpayer revolt.

This is not as farfetched as it may seem. The American Revolution was in great part caused by tax abuses, and the rebellious stream it embodied still runs below the surface. The increasing recourse to referendums and popular initiatives of all kind points to a growing disconnect between politicians and voters.

The political tea parties and town hall meetings of the past summer might just be steam blowing off. They can also be a portent of much deeper discontent.

Such discontent does not need outright tyranny to become prevalent. The 18^th century British government, compared to some modern states, was far from truly tyrannical. Britain already had, after all, a solid democratic tradition. Its fault was of another order.

The British lost America because the English Establishment could not countenance a challenge to its authority and to the status quo which upheld it. Our own government may suffer from a similar malady: an exaggerated belief in its own power and legitimacy, detached from the will and interests of the population. It sees itself as both self-sufficient and infallible.

The Gettysburg Address says otherwise. The American experiment still goes on, with leaders ultimately being seen as representatives of the people, not as a self-perpetuating elite.

In 1979, in what promised to be an easy military operation, the Soviet army invaded Afghanistan.

Six years later, with his forces bogged down in a costly and open-ended guerilla war, Mikhail Gorbachev gave his generals a year to win, with whatever means they needed to succeed. They failed, and the Soviet government spent the following three years extricating its forces. The Afghan failure was a major factor in the collapse of the USSR.

The Soviets had been in Afghanistan for seven years when they gave up and decided to withdraw. By now the US has been there almost a year more.

There is no intention here to establish a moral equivalence between the US and Soviet campaigns. The Red Army was brutal and ruthless, killing up to 15 percent of the Afghan population, and driving half of the remainder out of the country.

By contrast, the US went into Afghanistan to get the man who had gratuitously murdered nearly three thousands American citizens. The Afghans fought on our side against the hated Taliban. We were welcome.

Yet, from the military point of view, we have done no better than the Soviets. After nearly eight years we face a growing insurgency that is established in nearly half of the country, and reaching into the other half. We need to understand why.

Clausewitz defined war as the pursuit of policy by other means.

The means here are our military forces. They are professional, well trained, extremely well armed, and they have fought honorably and well. They cannot be blamed.

If the fault is not with the means, then the policy must be wrong. We started out with all the advantages on our side and won a quick victory. It was downhill from there. Why?

Let us go back to the Afghans for a while. They are not a nation, but a confederation of ethnic and tribal groups. They are poor. They practice various forms of Islam, which in the West are mostly considered retrograde.

Nevertheless they are a proud people and they can fight. In the 19^th century they took on the British Empire and kept it out of Afghanistan. They fought the Soviets and chased then out. They fought with us against the Taliban and won. Then we somehow lost them, and now the Taliban is back.

The reason is very simple: by our own choice, we changed from liberators to occupiers. Instead of giving Afghanistan back to its people we decided to keep and remold it to our own liking.

In a country that begs for a federal system, we set up an artificial central government with no popular support or power base. We disbanded the militias that fought for us and removed their leaders from power, and then proceeded to create our own Afghan army from scratch. We ran the place and still run it as if it belonged to us.

In other words, we left very little to the Afghans that they could call their own. We gave them freedom and democracy, but on our terms, not theirs. They don’t own it, and people will not fight to keep what they do not own.

We do, however, have one opportunity, which may well be our last chance.

The local government we so laboriously created and propped up has disqualified itself by rigging an election. This gives us a brief window to change tack, rework our policies and possibly start again.

There are still places in Afghanistan that the Taliban has not penetrated, like Bamyan province. This is where we should focus first and foremost; provide whatever economic aid is needed;  arm, train and support the locals, so they can defend what they have; promote local leaders and let them run their show. All in all, we must show that we will promote Afghan interests as they see them, rather than according to our own concepts.

Whenever this approach has been tried, as in Khost province for a while, it worked. If we applied it across the board, we could start pulling out our troops within a year or two.

It will require us to admit our mistakes and give up some cherished, if questionable, myths. But that is a small price to pay for a real victory.

In fact, such interventions fall into several categories, each of which has different effects.

Before doing any analysis, however, it is necessary to state that government operations do not create wealth.

Every dollar the government injects into the economy is taken out of the economy through taxation or borrowing. External government spending equals taxation minus the cost of government operations, so that the economic multiplier is always less than one. And since the cost of operations rises with size, the multiplier shrinks as the government gets bigger.

While government spending as a whole costs the economy more than it contributes, some government programs can have positive effects, particularly if certain intangibles, such as social or environmental benefits, are taken into account. The positive effect is the highest for activities which take advantage of the government’s specific strengths.

The main advantage the state has over the private sector is the ability to pursue long-term strategic objectives without the need to obtain results within a short time frame, as is the case with private profits. Therefore investment by the government will be most useful when it fits within the framework of a long-term strategy.

Thus the first and most potentially profitable area for state investment will be scientific research, particularly when it involves time frames which the private sector cannot afford. Such funding of research will be most effective within a clearly defined policy framework. Current sectors where such intervention would be very beneficial would be energy supply, resource substitution, environmental science and climate change.

The next area where government spending can be beneficial involves infrastructure projects which due to size, cost and duration are not affordable for the private sector. The Tennessee Valley Authority provides a good example of such work. The advantage here is not only the financial strength of the state, but also the ability to provide social and environmental benefits which are essential but cannot be provided at a profit.

Spending relating to the above two categories can and often will have a positive impact, the impact becomes negative for the following two categories.

The first negative spending area includes subsidies. These are counterproductive, not only because they skew the operation of the private sector towards inefficiency, but also for their effect on technical progress. A subsidized technology will not evolve because it favors a safe status quo over the riskier process of discovery and development.

The last and most wasteful category of government spending covers straight cash transfers. Their effects are always negative because of the principle formulated above: cash given to Peter must first be taken from Paul, with the state first taking its cut. In addition, the flow will inevitably be from the more productive sectors of the economy, which generate more tax revenue, towards the less productive ones.

In addition, cash transfers are an inevitable and self-sustaining source of political corruption.

It is true that the state is at times obligated to provide cash as part of a safety net, aimed at mitigating the effects of economic upheaval or natural disaster. The defining criteria of a safety net operation are specificity and limited duration. A safety net operation indefinitely extended in time inevitably becomes a cash transfer program. Before this happens it must be replaced with a more productive form of state spending.

Even a cursory analysis under the above criteria shows that the current stimulus programs, including the enormously expensive rescue of the financial system, fall mostly in the two lower categories, rather than in the more productive ones. Their economic impact will therefore be mostly negative, prolonging the current downturn and preventing a true recovery.

The oil cartel must be commended for their able management of the market. 2008 saw an extraordinary price spike which contributed significantly to the global recession. It was followed in short order by a price collapse threatening to bankrupt some of the oil producers. OPEC successfully weathered both, bringing oil prices back within a range tolerable for both oil sellers and users.

But the road ahead remains tricky. The global recovery is so tentative that even a small drop in supply could strangle it, while an increase could result in a new price collapse. OPEC members are fully aware of the immense liquidity pool created by central banks, with mountains of cash ready to flow into speculation on oil futures.

With such potential even a small tightening of supply can cause another massive spike, possibly higher than last year.

And this brings us back to inflation.

According to the U.S. Federal Reserve, inflation will not be an issue for a year or two, despite the huge recent increase in money supply. The recession has created so much spare manufacturing capacity that the price of goods cannot rise. In parallel, high unemployment will prevent labor costs from increasing.

There are, however, two ways to look at inflation.

One is to see it as a rise in the cost of goods and services. The gage preferred by central bankers to measure it is the so-called core inflation, which measures the price of a basket of such items, but excludes food and energy, considered too volatile.

The low expectation for future inflation is based on this definition.

The other way to understand inflation, however, is as a reduction in the value of money and, consequently, of purchasing power. This is the definition the average consumer lives by. This person is not particularly interested in core inflation, which deals with price changes in the longer term. But he or she is highly sensitive to the cost of food and energy.

In a nutshell, the prices which really impact the consumer, and particularly the U.S. consumer, are those of gasoline, beef, milk and eggs. They do so all the more if they become volatile. Prices of other items are less important because their purchase can always be delayed.

The volatility of food and fuel prices will not go away, because the gap between global supply and demand of both oil and foodstuffs has been steadily narrowing, and will close even faster if a true economic recovery occurs.

At that point the global liquidity so freely pumped up by governments will flow into commodities and almost instantly amplify any price increases caused by demand. We will then have 2008 all over again: the cost of essential items rises disproportionately, the consumer takes a major hit and retrenches, and the economic recovery goes into reverse.

After a few such episodes, the consumer will hunker down for good and deflation will set in.

In other words, there is a strong likelihood that the current policies will cause a series of narrowly focused inflationary spikes leading in the end to a deflationary situation. Because of the cognitive disconnect between the monetary authorities and the average citizen, the measures designed to fight deflation will instead result in entrenching it.

The problem lies with the almost exclusive focus of the central bankers on the financial system. In theory, the purpose of this system is to steer available funds towards productive investment opportunities. But the system has become so large and convoluted that its internal activities now trump investment in the real economy.

Speculation in oil futures is much more profitable than investment in a new oil field or refinery. The fewer refineries are built, and the fewer oil fields are developed, the more profitable speculation becomes, as it thrives on demand-supply imbalances.

If central bankers want to avoid a long and painful deflationary period, they need to understand that shoveling money into the financial system is only an initial step. What is critical is to push the money through the financial system and into productive uses.

Printing money is easy. Investing it well is the difficult part, but also the one that powers the economy.

The current occupant of the White House certainly has some leftist leanings, as do many members of the Democratic Party. But it might be more accurate to see his agenda less as a pursuit of socialism than as an extension of policies already initiated under his predecessor.

Let us review these policies, starting with foreign affairs.

As far as the Bush-initiated military conflicts are concerned, little has changed. The withdrawal from Iraq has not been accelerated and proceeds as the previous administration left it. A repeat of the Bush surge policy is being attempted in Afghanistan. Operations in Pakistan and Somalia are being pursued along previous lines.

China remains the predominant partner, with the Sino-American relationship now being extended beyond the economic realm to the strategic one. North Korea is allowed to fester so long as Beijing allows it, while Russia is being treated as a quasi-pariah, just as before.

The Bush policy of globalization remains in force. The remedy to the economic meltdown is, as previously, seen in government spending and various bail-outs rather than in investment in job-producing activity.

The primary emphasis remains on the financial sector, seen as the foundation and heart of economic activity, as opposed to the real economy. The provision of liquidity to the financial industry, at enormous cost to the taxpayer, remains the primary priority. At the same time domestic investment, which provides employment and income to the taxpayer, remains neglected.

It can certainly be argued that long-established policies cannot be changed within the space of a few months, or even a year. But the continuity between the two administrations reaches further then the above.

In domestic politics the main priority common to both is the continued increase and reach of the power of the executive branch.

Under the previous administration the doctrine of the unitary state was used to enlarge executive power in all areas relating to national security. In parallel the independence of the executive from legislative control was fostered by the generalized use of signing statements, through which the president took exception from many provisions of the bills he signed.

While the previous president used the War on Terror as the justification for increasing executive reach, the current one has relied primary on the economic crisis.

The financial meltdown has not only allowed to extract huge budget increases from a willing congress, but to extend executive reach into many sectors of the national economy. This extension has been accompanied by the creation of various offices and functions, collectively referred to under the term tsar, under exclusive White House supervision.

These offices, and the individuals who occupy them, are outside the regular cabinet structure as well as outside congressional supervision.

The development of such an extra-constitutional governing structure, erected hastily under the cover of economic urgency,  potentially leads to the creation of a parallel government hierarchy, free from constitutional checks and balances, and loyal only to the chief executive and his immediate circle.

Such a parallel hierarchy would be similar to the one erected in the Soviet Union by the Communist Party, with cells supervising government departments at all levels. The Communist Party, of course, was loyal only to the Party General Secretary, the de facto sole ruler of the USSR.

A development along similar lines in the U.S. does not necessarily signify the rising of a Marxist conspiracy, as some commentators have suggested. But it does signal a drift away from the principle of separation of powers supported by constitutional checks and balances. As such, it raises two red flags.

First we need to remember that the increased reach of the central government will further lower its efficiency. A bigger government with more extensive powers will not give us a better economy or a more efficient administration, but drifts instead towards the discredited Soviet model, which collapsed not because it was Communist, but because it was massively inefficient.

The second and more important point is that the U.S. constitution is not a quaint, antiquated document. It is one of the towering achievements of human political thought. This nation has been, through the kindness of fate and the wisdom and heroism of its early citizens, been blessed with this extraordinary code of political conduct. It behooves us not to discard it lightly for the sake of ill-guided expediency.

The immediate cause is that the respective policies of both partners are mutually incompatible.

The Americans are determined to go on printing and spending money by the boatload while the Chinese are adamant about preserving the value of their huge trove of dollar-denominated assets. There is not one square inch of common ground. As a result both parties are remaining very civil while simultaneously playing chicken as to who can intimidate the other.

There is a remote possibility that the global recession will end quickly and the old status quo restored to general satisfaction. But current reality points to massive U.S. deficits stretching far into the future and leading inexorably to the dollar depreciation the Chinese adamantly oppose.

But even the most optimistic economic scenario will at best gain only a short respite. Beyond the immediate issue of dollar value lurks the fact that key economic policies on both sides are nearing the end of their useful life.

Let us look at China first. The fiction here is that a thriving economy can be built without enriching the great mass of the population.

Aware of the collapse of the Soviet Union under the weight of its economic inefficiency, the Chinese government has created a semi-capitalist sector within its own command economy. But this sector is based on the export model, which requires other states to pay for China’s development while simultaneously creating massive financial imbalances.

Worse, it requires China to keep the bulk of its population poor in order to maintain its labor cost advantage. While some wealth has trickled down to the bottom, social and economic inequality has risen much faster. This is the very formula that has led to massive revolts and government collapses throughout Chinese history. China is not stable and getting less so.

The U.S., for its part, has bet that manufacturing and industrial activity can be replaced by finance. To that effect it has allowed its financial system to grow far beyond its original role as intermediary between providers and users of capital.

This policy has over the last decades made the U.S. financial system a world and an industry unto itself, with operations only tenuously connected to the real economy. Because of the potential of high profits resulting from speculative operations much of the investment capital needed by the real economy is siphoned into the purely financial sector.

Speculative financial operations produce both huge profits and enormous losses, making an autonomous financial industry inherently unstable. The U.S. government has chosen to ignore this fact during the current crisis, bailing the financial sector out at enormous expense, borne by taxpayers.

This by itself guarantees that the hoped for economic recovery will be deprived of the funding needed to generate economic activity and increased employment. It is thus likely that the vast and expensive rescue effort undertaken by the government will achieve little or nothing, with a severe political backlash leading to major policy changes.

If current policies on both sides are maintained, the probable outcome for the U.S.-China axis is that both partners will become increasingly dysfunctional, gradually rendering the axis irrelevant. And if the fundamental policies are changed the symbiotic relationship between the United States and China will fade, and with that the Sino-American axis will dissolve into thin air.  

In either case the much hyped relationship between the two powers and their economies has little or no future. History will most likely judge that it was a bad idea from the start.