Sometime last year, we were discussing with someone in the finance ?industry? about the possibility of a double-dip recession. Back then, the mainstream assumption was that government spending will somehow ?stimulate? the private-sector of the economy. But we argued that this assumption was simply incorrect. As we wrote in August 2009 at Will governments be forced to exit from ?stimulus??,

In fact, the word ?stimulus? is the most misleading word in economics lexicon because it conveys the idea of a surgeon ?stimulating? a heart into self-sustained beating. In reality, what government interventions did was to put the economy on a crutch.

Based on this faulty assumption, the financial market?s expectation is that the worst of the GFC is well and truly over and that the global economy will return to ?trend growth.? But as we wrote in January 2009 at Soft landing hope built on faulty framework assumptions,

Built into the blinkers of the mainstream neo-classical economic framework, the assumption is that the economy is like an elastic band that will spring back to its previous un-stretched state of ?equilibrium? after being stretched by external ?shocks? (e.g. global financial crisis). For those who studied economics at university, you will realise that the phrase ?external shock? is often used in the text-books to describe phenomena that are beyond the scope of economic model. Furthermore, you will find that your text-book are full of simultaneous equations, which implies some sort of ?equilibrium? has to unquestionably happen.

Today, there is a lot of talk in the financial markets about the threat of a double-dip recession. The expected (assumed is the more accurate word) recovery in the United States seems to be stalling. China is enacting policies to slow growth. Europe is mired in sovereign debt problems.

But for you, our dear readers, all these should not come as a surprise. As we already wrote in March this year at Black Swans lurking because Uncle Sam has less margin for error,

If the right word is used (e.g. ‘crutch,’ ‘prop up’) to describe the counter-productive government policies of spend, spend and spend, then it will do wonders to increase the economic IQ of the masses (see Are governments mad with ?stimulating??). Consider this very simple chain a logic:

1. Someone is falling.
2. You place a crutch to prevent him from falling.

Isn’t it plain common sense to see that once you remove the crutch, that person will crumble? From this, it follows that government crutch (‘stimulus’) lifts government expenditure to a higher plateau. Once we have bigger government, it is very difficult to shrink it as the difficulty currently faced by Greek government shows.

This is the issue that the Europeans are facing right now. If governments attempt to ‘stimulate’ their stagnant economies by spending big, their fiscal deficits will continue to grow, even to the point of no return. Consequently, the financial markets will lose faith in the governments’ debt because it will mean either (1) raising taxes, (2) default, (3) printing money, or (4) some combinations of the three. That’s their motivation for pledging to cut fiscal deficits in the recent G20 Summit.

But the problem is, if they cut their fiscal deficits (i.e. cut spending), their economies as measured by the GDP will shrink. Not only that, a shrinking economy implies a shrinking tax receipts for the governments, which in turn implies that they will have greater difficulty trying to repay existing debts. When that becomes obvious, you will see the bond and stock market reacting very negatively.

But for the Americans, since their government bonds are not yet under attack (given that among other reasons, the USD is still the world reserve currency), their more immediate problem is domestic growth. In fact, demand for American government bonds increased as a result of the flight to ‘safety.’ Hence, Obama was on record to urge the Europeans not to kill growth by shrinking government spending. But as Niall Ferguson said, at this current trajectory, the US will be like Greece in several years time.

So, who is right? The Americans or the Europeans?

Obama could urge for a policy of continued government spending because time is more on America’s side. The financial wolf packs are currently busy with Europe. So, Obama must be thinking that if America can try another shot at ‘stimulating’ their economy, maybe in due time, the government can then let the private sector take over. That will be the time to reduce the US government’s fiscal deficits. Hopefully, that can be done before the financial wolf packs set their sights on America.

Using an analogy, the current situation is like Europe being pressured on two fronts simultaneously with no room to move. America, on the other hand, is facing pressure only on one front. Obama’s plan is to send troops to that front, deliver the knock-out blow before sending troops to face off the looming second front. The plan will fail spectacularly if the enemy arrives on the second front before the knock-out blow on the first front can be concluded.

So, place your bet on whether you think America’s plan will succeed. If you think they can pull it off (i.e. honour their debts), then buy US Treasuries (American government debt). If not, get physical gold.