I have often commented on the remarkable optimism of markets given even a glimmer of hope — only at market bottoms does pessimism take over.  At tops, optimism seems unquenchable; that suggests we are at or near a top this week.

US markest rose sharply today.  Yet this week’s data say that the United Kingdom has officially dipped back into recession; China’s slowdown is confirmed by UPS; and US jobless claims are back up to their highest level since January (the upward revision of last week’s numbers; this weeks are just as bad).

Moreover, the European “non-negotiable” stability pact that was supposed to ensure Europe’s recovery has now completely fallen apart — Spain unilaterially reneged; the Netherlands will miss their assigned debt target and their government has fallen over plans to tighten austerity; and France — which was Merkel’s most reliable partner — now has one candidate who promises to toss aside the stability pact conditions (Hollande) and one candidate who promises to hold a referendum on whether to abide by them (Sarkozy).  Sarkozy is almost certain to lose, precisely because he backed the stability pact that would no doubt collapse in a popular referendum.

For from having been contained by firewalls in Greece and an imposed technocratic regime in Italy, the debt rot in Europe is spreading — not only do Spain’s debts look unpayable, France is looking shaky, and household debt in the Netherlands has soared to unsustainable levels.

This was all entirely predictable, because firewalls and temporary measures do buy time (as Mario Draghi proudly and rightfully states the ECB has done), but cannot solve the fundamental problems of debt that is excessive relative to GDP growth.  The problem has now been spread around by the mechanism of the ECB lending to European banks, who have in turn put the dodgy sovereign debt on their books, weakening the entire financial sector.  Not a smart move, in my view.

Much of this grief is self-imposed, in the form of the austerity policies embraced by Britain’s LibDem/Tory government, and imposed on all of the Euro zone by Germany.  These policies have made a bad problem worse, forced the ECB and IMF to use all their ammunition just to keep the wolves outside the doors, and left Europe looking at increasingly unpleasant options to deal with a problem that has now festered for five years.

We have been continually told by the conservative camp that a solid dose of austerity will lead to a sharp rebound in confidence, get government out of the way of private business, and get lending and the economy going forward again.  All of this is looking just as sound as the advice that regime change in Baghdad would be cheap and easy and create a swathe of pro-western regimes in the Middle East that would enable Arab-Israeli peace to finally be achieved.

The UK, one of the earliest and most consistent in its imposition of austerity policies, now is in the embarrassing position of GNP still being over 4% below its pre-Recession peak.  The number of people queing at food banks has doubled this year, and British bank lending to businesses is sharply down.  What more would it take to make officials admit their policy has failed?  Yet they refuse: Chancellor Osborne has vowed to push ahead with his fiscal austerity plan, presumably until UK voters follow those in Spain, France, Ireland, and elsewhere in pushing austerity-addicted governments out of office.

The nature of the “Great Recession” continues to be misunderstood.  It is a double-whammy — a major cyclical downturn caused by excess financial leveraging and a credit collapse that just happens to occur simultaneously with a major long-term structural change in underlying demand.  That is, we reached a demographic turning point in 2011 with the labor force growth in the advanced nations starting a sharp decline or even reversal, as the low fertilty of the last 20 years and the aging of the baby-boomers hits the workforce.  This has led to a built-in structural bias toward deflation, as household formation in rich countries slows, while consumption in emerging markets is not yet able to pick up the slack, and while growth is those markets is still too heavily geared to selling goods to the now slower-growth rich countries.

Thus even without the cyclical prime mortgage and housing busts, we would be heading toward a longer period of slower output and consumption and deflationary pressures.  That means that even if the cyclical crisis was resolved, there would be no simple ‘return’ to the old ‘normal’ as the motors of growth from the late 20th century have gone.  So to respond to the cyclical crisis with austerity measures is just to reinforce the very structural factors that have already started to weaken growth; this cannot change the basic problem of debt to GDP ratio, because “natural” GDP growth is not just lurking behind the veil of bad government policy or excess spending waiting to return if government is reined in.  Instead, austerity just chokes growth further.

The solution needs to be short-term stimulus to help counter the cyclic crisis, with longer term limits on entitlements to reduce FUTURE government spending.  But the ratio of GDP to existing debt cannot be improved without either devaluation to reduce the real value of the debt (which Germany prevents for the Euro, and which the US role as international reserve currency also prevents for the dollar) or efforts to compensate for the structural factors hampering growth by implementing strongly pro-growth policies.   Such policies are easy to identify — opening up immigration especially for skilled immigrants or entrepreneurs; investing in basic research and tax policies to further favor industrial R&S;  support for education; targeted policies to restart the housing market; infrastructure construction; free trade policies.  Yet most countries are doing the reverse or dragging their feet on these, or pushing measures aimed simply to boost business’ bottom line (which is not the same as growth, as we have learned the last two years).

My hope is still that in 2013 or 2014 voters and politicians will give up their blind faith in austerity and other false idols of conservative faith, and start a hard search for policies that will give back growth.  In the 1930s, it took six or seven years for this to happen, and in parts of Europe facism took over first.  Perhaps the most alarming news in the last week is the huge increase in support for and influence of far left and far right parties France and the Netherlands.  Hitler did not become Chancellor of Germany because a majority of people voted for him.  He became Chancellor because just enough people were frightened of a surge of the far left to support his far-right party, and just enough was about a third of the electorate (only about double what France’s far-right National Front Party garnered last week).  There are no signs yet we are headed there, but this is no time for complacency.  Politicians and economists need to get serious about growth policy, not austerity, or more trouble lies ahead.