The increasing divergence of the economies of the United States and the European Union, and the sluggish statistics coming out of the former, point to one inescapable conclusion: the US policy mix, in fiscal, monetary and regulatory areas, has been uniquely bad.

This is not simply a question of party or ideology: under the Democrat Bill Clinton administration, economic policy was pretty good, while the present Federal Reserve chairman, Ben Bernanke, was appointed by a Republican president. Nevertheless, the combination of misguided theories and poor execution is now doing damage to the US economy that will take a very long time to repair.

Begin with monetary policy, a subject that has been a staple of this column since it began in November 2000. The effect of the loose money of 1995-2008 on creating the bubble and reducing the US savings rate to zero has been acknowledged by most observers since the days in late 2008 when pillars of the US financial system were still crashing about us.

Given that the horrible error was realized by everybody but Bernanke so early on, you'd think something would have been done about it. No such luck. Interest rates have been stuck close to zero for more than 18 months, while inflation has never shown the slightest tendency to go below 1.5-2%. Indeed if you remove the Bureau of Labor Statistics fudges from US price series and look at the "harmonized" series produced (in an obscure corner of its website) by the bureau itself, in which it compares inflation in the US to that in other countries, all calculated by EU methodology, you will find that the 12-month rate of US price inflation was 3.2% as of May 2010.

A brief period of very low interest rates after the crash might have been expected - though we should in this context remember Walter Bagehot's advice in a financial crash to lend large amounts of money at very HIGH interest rates, not low ones. However, zero interest rates that persist for close to two years, in a period when inflation remains safely positive, become indescribably damaging, especially when they follow more than a decade of monetary policy that was erroneous in the same direction.

Instead of correcting to a sustainable level, the US savings rate, deterred by the negative returns available, has once again become inordinately low. So also has the lending rate to small businesses, since banks can borrow at close to zero, invest in government guaranteed mortgage bonds at 4-plus percent, leverage 15 times and retire to the golf course. Who needs the aggravation of lending to small business, anyway?

On the fiscal side, it can now surely be recognized that the US$800 billion fiscal stimulus passed in February 2009 was a mistake. A recent European Central Bank study studied fiscal stimuli from the past, and calculated that the average "multiplier" of fiscal stimulus was about 0.5 - in other words, for every $100 billion spent on stimulus, only about $50 billion was added to output, with $50 billion being lost from the private sector in "crowding out" and the original $100 million being borrowed and added to debt.

In practice, it seems likely that multipliers vary according to a number of factors. The fiscal position before stimulus is undertaken is one: if the stimulus puts the government only modestly into deficit, then "crowding out" is unlikely. Another is the state of the economy; "crowding out" is less likely in a very deep depression, like that of 1929-33, because private spending is already so depressed. A third is the savings rate; "crowding out" is likely to be less when, as in Japan, the domestic savings pool is very large and being added to substantially. Finally, the contents of the stimulus package matter a lot; a reduction in high marginal tax rates may well have a supply-side effect, while investment in bottleneck infrastructure may also yield a high return that increases the "multiplier".

The Chinese stimulus package of 2008 passes most of these tests. It was imposed on a budget that was initially in surplus. It consisted mostly of infrastructure (though the Chinese government may not have chosen the infrastructure optimally). China has a very high savings rate, so "crowding out" was minimal. Only the state of the economy was in question; although exports dropped sharply in the winter of 2008-09, the Chinese economy never went into recession, so the stimulus risked producing overheating, which now appears to have occurred.

The US stimulus package was at the opposite end of the scale. The economy had suffered a major financial shock, but it was too early to tell whether it was settling into a long period of stagnation. US savings rates were very low, so the chances of deficits crowing out private activity were substantial. The deficit was already large, and swollen by the bank bailouts, making "crowding out" more likely. Finally, the quality of the stimulus package itself was very poor, with large amounts of pork-barrel spending and subsidies to heavily unionized public sector workforces.

It is thus not surprising that the US stimulus appears to have had a net negative effect, with a multiplier that was very low or even below zero. This was not unknowable beforehand; a study "Public Employment and Labor Market Performance" in Economic Policy as far back as 2002, based on data from the Organization for Economic Cooperation and Development, had shown that on average creating 100 public sector jobs destroys about 150 private sector jobs and increases net unemployment by about 33. One would like to think that policymakers boned up on this stuff before taking office.

The US economy bottomed out in about May 2009, before stimulus spending took effect, but it has recovered far more slowly than might have been expected, with very anemic job creation. European Central Bank president Jacques Trichet wrote earlier this month that every country should be moving to balance its budget and raise interest rates to normal levels as quickly as possible, and that speed in imposing stimulus should not be followed by sluggishness in removing it.

The United States and Japan were the two most obvious targets of his remarks; it is indeed notable that the EU, where stimulus was smaller and is now being reversed, has recently shown a much healthier growth trend than the United States. When traditionally Keynesian, big-spending Europe is rebuking the US for its profligacy, it is clear that policy has gone seriously adrift.

It is not just fiscal and monetary policies, however, that are posing problems. The complete lack of reform of the US housing behemoths, Fannie Mae and Freddie Mac, and the miscellaneous subsidies and handouts to the housing market have both wasted resources and hugely distorted the market. Instead of finding a true bottom at a price level at which the market cleared, the housing market in 2009 found a false bottom, with prices still above the 50-year average, in terms of incomes. The Case-Shiller 20-city house price index, based at 100 in January 2000, is still at a relatively lofty 146.45, having overall risen faster than consumer prices during the decade.

However housing was not in a slump in January 2000, far from it; it had benefited like other assets from the immense easy-money stock market boom of the late 1990s - prices were a third above their lows of 1993. Now that the artificial subsidies for housing are being removed, house prices will start to slump once again, and may well fall further than they would have done initially, as the false bottom has locked millions of new buyers into overpriced houses, further damaging market confidence.

The US government guarantee of home mortgages needs to be ended, the market needs to be returned as far as possible to its local origination buy-and-hold model, in which credit assessment and monitoring can be carried out effectively, and the mortgage interest tax deduction needs to be removed. Only then will the housing market become healthy; the resources poured into it since 2008 have made the problem much worse.

While Fannie and Freddie represent a gap in legislative activity, the manic activity on pretty well all other fronts has also been damaging. The healthcare bill increased costs in healthcare, without doing anything significant to reduce that market's grotesque distortions; it has thus added additional cost and uncertainty to the US economy, although most of that cost is several years in the future. In addition, while "cap and trade" climate change action has been stalled for the present, the prospect of it remains there, blighting investment in a number of sectors. The arbitrary ban on deep sea drilling is an additional example of policymaking that is both whimsical and vindictive.

The financial reform bill fails to achieve real financial reform because most of the key provisions - the Volcker Rule for example - were gutted after lobbying by the financial industry. Nothing significant was done to reform risk management, which remains a huge weakness. A Tobin transactions tax on financial transactions, the one provision that could have done some real good by reducing rent-seeking and rebalancing the sector from traders towards corporate financiers, was completely ignored by the "reformers", who thus failed to address the sector's largest single problem.

It now appears that financial "reform" has had serious unintended consequences in the bond market. The reformers correctly addressed the problem of rating agencies failing to understand the securities they were rating, but their solution was typical of a Democrat congress, opening the rating agencies up to the depredations of the trial lawyers.

At present, the rating agencies are refusing to give ratings because of their potential legal liability, and so activity in the bond market has ground to a halt. If the problem persists, corporate bond issues may remain feasible because investors are capable of doing their own credit analysis on corporate credit. However securitizations, in which a miscellaneous pool of assets is bundled together, become impossible without the rating agencies because the cost to each investor of investigating the asset pool properly is prohibitive. Even though a move back from securitization to buy and hold in the housing market is desirable and reduced outstandings on credit cards equally so, removing the current provision for those markets without providing an acceptable alternative is highly economically damaging in the short term.

It is thus not surprising that the US economy is sharply underperforming its competitors. It has been subjected to policy choices from all policymaking participants that were poorly designed and arbitrary in their application. The successes of Chancellor Angela Merkel in Germany and the new David Cameron government in Britain demonstrate that with better policy, much better results could have been achieved.

Martin Hutchinson is the author of Great Conservatives (Academica Press, 2005) - details can be found at www.greatconservatives.com.

Originally appeared in PrudentBear.com.

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