One of the problems with orthodox economics is it misses the point on human behavior. Orthodox economists build their models around the assumption of rational behavior of large groups of people. There is therefore always a gulf between this type of economic theory and the real world.

We know from Jeremy Grantham’s work on the “presidential cycle” that stock values rise on average 22% (based on the S&P 500) in the third year of a presidential terms relative to years one and two. This is not statistical noise. It’s evidence of the power presidents have to puff up stock markets through financial stimulus, political maneuvering and moral hazard.

Nobody who seeks political power is ever happy to give it up. So presidents try to give the economy a helping hand in time for elections. Bush, helped by a pliant Fed chief, did a better job at this than most. To say that the Fed’s monetary policy was loose in the run up to Bush’s reelection campaign is an understatement of epic proportions. George Junior had learned an important lesson from his father’s presidency: recessions don’t get you reelected.

Of course, the ensuing expansion of credit also helped by loose regulation of the shadow-banking sector and derivatives markets, couldn’t last forever. And the hero of the 2004 presidential elections left office during the biggest economic disaster since the 1929 crash.

President Obama knows his presidency will stand or fall on voters’ perceptions of his ability perform major triage on the wounded US economy. It does not, however, matter to Obama’s reelection bid if the economy assumes a sustainable pattern of growth; a good old-fashioned dose of ‘stimulus’ will do. Obama’s playbook is to borrow and spend America out of trouble. It is a short-term remedy at best. At worst, it will ruin the country.

The government will borrow 50 cents of each dollar it spends for the next year. To do this it will run the largest annual fiscal deficit since the US mobilized for World War II. There are only two ways to pay off the debt pile George W Bush and Barack Obama have run up. (President Clinton left office with a budget surplus.) The government will either raise taxes via the IRS or trigger inflation. It will likely resort to a combination of both.

This point is not lost on even Obama supporters. Warren Buffett had this to say recently about spiraling deficits:

A country that continuously expands its debt as a percentage of GDP and raises much of the money abroad to finance that, at some point, it’s going to inflate its way out of the burden of that debt.
Every country that has denominated its debt in its own currency and has found itself with uncomfortable amounts of debt relative to the rest of the world, in the end they inflate.
That becomes a tax on everybody that has fixed dollar investments.

Buffett thinks the ratio of debt to GDP in the US could reach 80% by 2011. Right now, the government has backstopped roughly 70% of the US economy with public funds. This is not a free market by any stretch of the imagination.
It is difficult to understand how the government will extract itself from this situation without triggering another collapse.

As we have said before here at Notes, traders and investors are now betting on Uncle Sam’s support of the market, not the market itself.