The ongoing debate on the so-called “jobless recovery” is intensifying. The Obama line is that his aggressive (massive) spending “saved the economy from the brink” and current stagnation is part of a long term problem created by Bush ineptness. Finishing the job requires more government intervention and debt, as the free market is simply unable to do the job without government supervision. The notion of a second stimulus has been bantered around by some on the left as well. 

Republicans have largely rejected the Obama narrative, but don’t seem to be clear about what should be done. Some are suggesting business tax credits for new hires or temporary income tax cuts. These are not bad ideas per se, but they don’t directly address the core problem, harmful government intervention in the economy. It’s crucial that Republicans reject the Keynesian thinking and social engineering that got us into this mess in the first place, and these ideas don’t quite hit the mark.

The notion of a temporary tax cut is appealing at first glance, and is certainly better than more government spending. The problem with this proposal is that tax cuts only reduce the size of government when they are permanent and are accompanied by spending reductions. The Obama balance of high taxes and higher spending is unsustainable and economically irresponsible. A temporary tax cut suggests that Obama’s approach may not be optimal at the moment, but could be workable when the economy recovers. Nothing could be further from the truth.

Likewise, a tax credit for businesses that hire workers could have some short term positive benefits. But providing a temporary tax break for new hires encourages companies to hire workers whose value to the business would be less that the wages they pay. Such a program amounts to a government subsidy, and layoffs will follow when the tax credit expires. If businesses cannot afford to hire workers, then why not reduce their regulatory burden and taxes on a permanent basis?

Obama’s massive government intervention has failed, and Republicans must decide how to respond. One option is to propose a blend of conservative and neo-Keynesian programs that don’t address the core problem of fiscal irresponsibility and Constitutional neglect. The pundits tell us that such a proposal would attract moderates to the fold. Bush drifted in this direction during his presidency and lost the conservative base. McCain tried a similar approach in 2008 and never got it back.

Another option is to tell the complete truth. Many Americans sense something terribly wrong with Obamanomics and are open to an alternative. The left’s healthcare package wreaks of big government and restrictions on individual liberty, and those who thought the Dems were about responsible change are seeing the party for what it really is. Republicans have a chance to propose a real solution, not just a shift to the middle. 

So what should a real solution look like? Here are a few pieces of the puzzle:

1. An immediate halt to all stimulus spending.

2. Permanent tax cuts, including a simplified flat or fair tax system, a substantial cut in the capital gains tax, and the elimination of wealth transfer through the tax code (i.e., earned income tax credits). 

3. A substantial reduction in the size and scope of government that brings about spending cuts and reduced regulatory burdens on business.

4. A reorganization (if not elimination) of the Fed to end its meddling in the economy.

5. An end of global negotiations on climate change. The evidence for anthropogenic global warming is spotty at best. Cap-and-trade and other socialist schemes should be summarily rejected.

If you think I sound a little extreme, you’re right. Capitalism is the solution to our economic problems and need not be “kept in check” by bureaucrats. We owe no apologies for a system that created the wealthiest nation on earth. It’s time we take a real stand. The Dems have given us a perfect opportunity to do so. We might not get another chance.

You know things are bad when the Chinese lecture you about free market economics. Recall the laughter Geithner received from Chinese students five months ago when he assured them that their dollar-based assets were secure. Well, the following appeared in this morning’s Wall Street Journal:

Liu Mingkang, chairman of the China Banking Regulatory Commission, said that a weak U.S. dollar and low U.S. interest rates had led to “massive speculation” that was inflating asset bubbles around the world. It has created “unavoidable risks for the recovery of the global economy, especially emerging economies,” Mr. Liu said. The situation is “seriously impacting global asset prices and encouraging speculation in stock and property markets.” Early Monday, a spokesman for China’s Ministry of Commerce added further criticism of the Obama administration, targeting recent measures by Washington against Chinese exports. “We’ve always known the U.S. and the West as free market economies. But now we’re seeing a protectionist side,” the spokesman, Yao Jian, told a monthly press briefing. Mr. Yao also rejected criticism of China’s currency policy, saying the yuan’s exchange rate has little to do with trade imbalances with the U.S. and that China should keep the exchange rate stable.

Liu Mingkang must have ready my post last week on the state of the economy. The Fed is keeping interest rates too low (below market rates), encouraging risky and otherwise questionable investments that would otherwise not be made. Our economy should be adjusting to the recession by allowing the transfer of capital from less productive enterprises to more productive ones. Instead, the Obama administration and the Dems in Congress are spending massive amounts to control the economy and discourage this regenerative process. It’s a blend of Keynesian economics and Marxism that even perplexes the Chinese.

I don’t agree with the Chinese position on the yuan’s exchange rate. The weak dollar is supposed to be good for exports in the short run, but has little effect on trade with countries like China whose currency value is largely tied to the dollar anyway. We can’t really lecture the Chinese on letting the market determine currency exchange rates when we are attempting to control the market in every other respect. Either the market works or it doesn’t.

The problem is really bigger than this. The U.S. is no longer the standard for free market economics. We’ve traded our moral authority and influence in the world for “change we can believe in.” I just hope we can keep a lid on the current socialist experiment until the 2010 elections.

Recently we have been getting mixed messages on the economy. On the downside, the burgeoning budget deficit is fueling the growth of our national debt at an alarming rate. The value of the U.S. dollar has been slipping as well. Unemployment broke the 10% barrier and no immediate turnaround is in sight. On the upside, stock prices have risen, replenishing the retirement accounts of many ordinary Americans. Retail sales seem to have stabilized, suggesting things might be getting better.

These positives and negatives appear contradictory at first glance, so let’s take a step back and consider the big picture. First, my guess is that unemployment is probably stabilizing. Unemployment shifts typically lag behind stock prices. Firms tend to delay layoffs as long as they can when the economy begins to slip, and they don’t hire back workers quickly when the economy begins to recover. The mixed signs of recovery suggest that employers might sit on the sidelines a little longer. If I’m correct, we could see an unemployment rate in the 10% range for a while.

Second, the stimulus package has had a modest short term effect, but one that cannot be sustained. Massive and irresponsible government spending has eroded confidence in the U.S. dollar, a problem whose long term effects will work against us when the economy attempts to recover. Countries like China, Korea, and Russia are heavily invested in the dollar and continue to buy enough of our debt to avoid a precipitous currency decline. These countries clearly want to diversify their currency holdings, so we can expect them to shift their holdings away from dollars when they have an opportunity in the future.

Third, the stock market’s recent climb is a welcome sign, but it’s probably demand driven. U.S. stocks are still relatively attractive when compared to those in other nations, but a key driver here is interest rates. In an effort to spur economic growth, the Fed is keeping interest rates artificially low, even below projected inflation. This might help borrowers, but these low interest rates translate into low returns for savers. Banks are offering 1-2% at best, which means that returns on “safe” investments won’t cover anticipated inflation. The only way to keep pace with inflation today is to put funds at risk, and the stock market is where investors typically do their gambling. However, the increased interest in gold and other commodities is evidence that many are skeptical about a sustained recovery.

What does this all mean? In my view we are experiencing a temporary and artificial recovery sparked by massive government expenditures that must be repaid and an easy money policy that encourages individual risk and overconsumption. Sooner or later this house of cards must tumble like the last one. Barney Frank and others are even talking about fortifying the Community Reinvestment Act as if its devastating effect on the economy over the last couple of decades wasn’t enough. The best case scenario is that Washington will come to its senses and pursue real economic change before it’s too late. A more realistic one is that we will experience a modest recovery of sorts for a season—possibly followed by slow growth or stagnation—and slip back into another recession thereafter. Sooner or later we must pay the piper. I’m hoping for the best, but preparing for a much more sober future.