The economy can recover and still be sick.

Sound impossible? It's not. And anyone buying stocks to benefit from a


-engineered recovery should consider just how deeply the central bank's efforts have hurt this economy, and how lasting the damage is likely to be.

Picture a drunk who gives up booze by going cold turkey: Only after returning to the bottle does he think he can function. Then think of the U.S. economy. It guzzled easy credit till 1999, when the Fed cut back the supply of cheap money. That caused the economy to hit the skids. To get the economy back on its feet, Fed Chairman Alan Greenspan has been letting the monetary spigots gush forth again. The result is an economy that's certainly more active. But you can hardly call it stable.

The New New Economy

For sure, this isn't the consensus diagnosis right now. But the consensus is wrong, and to demolish it, we must first understand it.

The markets love the economy's prospects. Stocks are up so much that they are proclaiming the advent of a new Golden Era for U.S. corporations. The

S&P 500

is trading at 23 times expected 2002 earnings, a highly confident bull market valuation. Bonds display the same optimism, albeit more faintly. They're down from recent highs, indicating that a recession has been avoided and that manageable growth is returning.

Many economists -- Keynesians and monetarists alike -- applaud the Fed's loosening. In their view, the economy isn't drunk but undernourished. The monetary stimulus it's getting is healthy and necessary, they say, especially after a shock like the Sept. 11 massacres. Money creation has been prolific: M2, an indicator that measures certain forms of money, is up 11% from year-ago levels. The last time we saw such a steep increase was in the crazy days of the early '80s.

The speed with which this money moves through the economy is slower than in the past, and this explains why the massive increase in the stock of money hasn't sparked growth. But when money flows do begin to accelerate -- and the soaring stock market is a sign that they have -- the economy should perk up. In normal conditions, money can be wiped out only if people pay off debt -- and there isn't much of that going on with interest rates as low as they are.

With money aggregates as high as they are, inflation fears would normally abound. But the mainstream economists point to numbers showing companies operating below capacity, and they see none of the bottlenecks that normally cause prices to rise too fast.

Moscow on the Hudson

Clearly, if growth returns and inflation stays low, the stock market isn't quite as crazy as it looks. But one thing we've learned over the past five years is that the stock market has no idea about economics.

First off, it implicitly trusts the Fed. But most of the central bank's actions are harmful. Many economists will readily agree that the government has no role in setting prices. But influencing the cost of credit -- which is what the Fed does -- is somehow OK. If government-set prices create distortions, then making loans cheaper than they should be is also problematic, surely? Unconvinced? Well, consider this: It was the Fed's artificially low interest rates that sparked billions of dollars in wasted investments in telecom networks and Internet companies.

The collapse of those investments caused the crunch we're going through. However, by reducing interest rates to avoid a recession, the Fed is creating the conditions that will allow many of those companies to remain in business, or at least prevent further downsizing. Thus, the distortions will remain.

As heartless as it sounds, a recession would have sped up the process of freeing up the capital (defined not as money but as people, ideas and plant) that is trapped in flawed businesses. Without a true correction, the Fed has set the stage for an economy that is bound to perform erratically. This is exactly what's happened in Japan, where accommodating governments and banks have put off the tough measures for more than a decade.

However, a manageable recovery is not here and it is not guaranteed. In fact, the Fed still faces two big risks to its reflation strategy.

Red Herring

First, the downside variety: The massive money creation may not be enough to stop the slide. The buoyant housing market has helped keep the economy afloat. Housing prices have been supported by a flood of mortgage lending that has been supported by government-coddled

Fannie Mae


Freddie Mac

. The amount of mortgages Fannie has kept on its own balance sheet soared 50% in the 10 months through October, to $230 billion. As with all bubbles, that sort of growth almost certainly means problems down the road. Housing market collapses usually follow stock market debacles by two to three years. If the slide in house prices happens in 2002, and it hits Fannie and Freddie and other lenders, the economy could be in real trouble.

Then, there's the upside risk. A recovery may rapidly lead to high inflation, given all the money waiting on the sidelines. A couple of recent declines in key inflation indices has sparked talk about deflation. However, the Cleveland Federal Reserve's median consumer price index is showing a 5% -- yes, 5% -- annualized increase for October. How can this be when capacity utilization is so low? Because of insufficient capacity in certain industries. Housing costs are rising, presumably because of supply constraints. The same likely applies to health care costs -- another area in which inflation is hot.

Don't buy this economy another drink. It's soused as it is.