Who can magically fix the economy? No one - Full version

FORTUNE -- Let us tell you an ugly truth about the economy, a truth that no one in power or who aspires to power wants to share with you, at least until after the midterm elections are over.

It's this: There is nothing that the U.S. government or the Federal Reserve or tax cutters can do to make our economic pain vanish overnight. There are no all-powerful, all-knowing superheroes or supervillains who can rescue or tank the economy all by themselves.

From listening to what passes for public debate in our country, you'd never know that. You'd think that the federal government could revive the economy quickly if only Congress would let it be more aggressive with stimulus spending. Or that the Fed could fix it if only it weren't overly worried about touching off inflation. Or that the free market could fix it if only we made deep and permanent tax cuts. Watch enough cable TV, listen to enough talk radio, read enough blogs and columns, and you'd think that they -- the bad guys -- are forcing the country to suffer needlessly when a simple and painless solution to our problems is at hand.

But if you look at things rationally rather than politically, you'll see that Washington has far less power over the economy, and far less maneuvering room, than many people think. "It's endemic in our type of society that we always think there's a person who holds the magic wand," says Sen. Judd Gregg (R-N.H.), a fiscal conservative who isn't running for reelection, so he can, well, be blunt. "But this society and this economy are far too complex to be susceptible to magic wands."

Heaven knows we could use such a wondrous fix. Even though the Great Recession ended 16 months ago according to the business-cycle arbiters at the National Bureau of Economic Research, that means only that the economy started to grow in June 2009. It doesn't mean that the economy's healed. It certainly doesn't mean that the recession's victims have healed. Tens of millions of people are still economically wounded from declines in their home values and investment accounts. Worse, despite some modest employment growth we're down almost 8 million jobs from the end of 2007, when the Great Recession officially began. Now, on to the real problems in the economy: why they've been so resistant to the traditional cures of lower interest rates and higher government spending. And we'll show you that, when you talk to them in private (albeit on-the-record) forums, people from across the political and economic spectrum agree that there's no magic cure for what ails the economy.

The fact is that our nation has suffered a huge financial trauma, in the double-digit trillions, and it's going to take years to get well again. This isn't exactly unknown in Washington -- but it's not something people in power go out of their way to emphasize.

For President Obama, who campaigned on the promise of transformational change, it's been especially tough medicine to deliver. Take his performance in a September town hall session on CNBC. People in the audience were looking for immediate solutions to their problems, and Obama seemed to struggle with how to answer them. You can see why. Look what happened to the last President who ran for reelection during bad economic times: George H.W. Bush, in 1992. Bush came under fire for not doing more to help people who lost their jobs in the recession that had started in 1990, and for not showing more empathy in public. After losing to Bill "It's the economy, stupid" Clinton, Bush blamed Fed chairman Alan Greenspan for his defeat. (If Greenspan had cut interest rates, the thinking goes, it would have looked as though Bush were doing something.) Seven weeks after Election Day, the recession arbiters announced that the downturn had actually ended in March 1991 -- some 20 months before the election. Bush was right, as it turned out, not to push for extraordinary measures. But tell that to the voters.

If you think Bush had troubles, imagine what Obama is wrestling with. Today's economic problems have proved enormously resistant to the traditional rate-cutting cure Bush wanted "Maestro" Greenspan to order up. That's because the Great Recession, whose aftermath we're living through, was different from the 10 previous post-World War II recessions.

Those slowdowns were caused by the Fed's raising short-term interest rates to combat inflation. Recessions caused by the Fed's raising rates could be cured by the Fed's lowering rates. If things looked especially dicey, the federal government would send people checks to generate economic activity and spur confidence.

Independent but not all-powerful

But the Great Recession was different: It was triggered by a financial meltdown brought on by excessive lending, reckless risk taking, the implosion of an unregulated shadow banking system that assumed that short-term money would always be available -- and ignorant and careless borrowing by people and institutions. The recession's genesis is why things are still sluggish even though the Fed has cut short-term rates, which it controls, to virtually zero, and has forced down long-term rates, which it doesn't control, by buying more than $1 trillion of securities in the open market, and letting it be known that it and other central banks will buy more.

Yet although such "quantitative easing" -- econo-speak for "printing money" -- helped allay financial panic in 2009 by providing cash to institutions that needed it badly, it's less effective and more risky to use it to stimulate the economy. Hence the knife fight at the Fed board of governors between the fans of quantitative easing and those opposing it.

Let us explain. Even though the Fed is very powerful, it's not all-powerful, just as the U.S. is not all-powerful when it comes to its own financial affairs. The Fed has to worry not only about the U.S. economy and money supply, but also about debasing the dollar too much too quickly, lest it spook the foreigners who finance our trade and federal budget deficits. If foreigners lose faith in the dollar's value, it could run our interest rates up sharply and abort any recovery.

To its credit, the Fed -- the one institution that because of its independence can actually act quickly without making a political show -- sort of admits that its power is limited. "Central bankers alone cannot solve the world's economic problems," chairman Ben Bernanke said in a speech at the Fed's conclave in Jackson Hole, Wyo., in August.

The Fed wouldn't let us interview Bernanke about the limits of the Fed's power. It's easy to see why: He'd risk diminishing what remains of the Fed mystique by talking on the record about limitations and problems.

However, former Fed vice chairman Donald Kohn, a 40-year Fed veteran, agreed to discuss those limits, provided we made it clear he was speaking for himself as an outsider, not for the Fed. "The Federal Reserve can make a difference, but it doesn't have a magic bullet," said Kohn. "It can't take a weak economy facing a lot of major challenges and rapidly turn it into a strong economy."

Kohn isn't alone in that view. "The public has been sold this notion that somehow we can control the economy -- that we can fine-tune it so we don't get inflation on the upside, we don't get recessions on the downside, [that] when something happens, they can step in and offset it," says another long-time Washington insider, Douglas Holtz-Eakin. "The economics profession is painfully aware that this is just not true, and [that it] has a terrible impact on politicians, Presidents in particular."

Holtz-Eakin, president of the American Action Forum, a conservative think tank, was John McCain's economic adviser in the 2008 campaign. He and his Democratic counterparts know the dirty little secret: that the huge financial trauma suffered by the economy won't disappear overnight. "No one has found a way to have an incredibly severe financial crisis and snap back a year or two later," says Jason Furman, deputy director of the White House's National Economic Council.

Look at the numbers and you'll see why. The biggest single source of wealth for many people -- their home equity -- has fallen almost 50% from its peak in 2006, according to Federal Reserve statistics. Loss: $6.5 trillion. U.S. stocks are still down 25% from their peak in 2007, their 75% gain in the past 19 months notwithstanding. Cost: $4.8 trillion. Then there are the 7.7 million lost jobs with their associated lost income, lost wealth, and lost consumer spending. Loss: untold trillions. This wealth-reducing trauma, combined with consumers becoming afraid to spend and lenders changing from being ultra-lax to ultrastrict, has sucked huge amounts of money from the economy. Don't let occasional upticks in consumer spending, the stock market, or home equity fool you into thinking that things are okay, because they aren't. "The economy suffered a really deep wound -- it's healing, and it's a little bit uneven," says Alan Krueger, assistant Treasury secretary for economic policy, "but that is what you'd expect given the loss of wealth from the financial crisis."

People used to collectively spend more than they took home -- hence, our negative national savings rate, which was covered by borrowing. Now we're spending 6% or so less than we're taking home. That's a big headwind to fight. The switch from borrowers to savers augurs well for the long run, if the trend lasts. But in the short run, it hurts the economy by diminishing activity. Compared with all the losses we've talked about, the $814 billion in stimulus spending -- the effectiveness of which we won't get into today -- is small beer.

Many ideas but few solutions

So what do you do? One proposed solution is to jump-start the economy with deep and permanent tax cuts. That's more than a little problematic, given that the Great Recession began in 2007, when tax rates, especially on investment income, were about the lowest in modern times and there were no "Obama tax increases" on the horizon. George W. Bush had pushed through two big tax cuts -- one in 2001 because the government was supposedly taking in too much money, the second in 2003 to stimulate investment. But the economy tanked anyway. The latest tax-cut screed, the Republican party's Pledge to America, is economically incoherent. It has no meaningful numbers, proposes no changes in programs like Social Security, Medicare, and defense, and asks no sacrifices of anyone, yet says it can balance the budget. Good luck with that.

What about having the Treasury engage in a massive stimulus program to put money in people's pockets and have them spend it, ginning up economic activity and restoring confidence? But stimulus money has to come from somewhere -- and it doesn't seem possible for the Treasury to raise a few trillion more stimulus bucks without dire consequences to interest rates and the dollar's value. It doesn't help that the administration wrongly predicted that its stimulus package would hold unemployment to 8%; the rate soared to 10% and still hangs stubbornly in the mid-nines. Other institutions, such as the Fed and the Social Security Administration, both nonpartisan, also underestimated our economic problems. But the administration's mistake, which seems to have been an honest one, has undermined its credibility. The fact that stimulus programs seemed designed to favor unionized workers, a core Democratic constituency, didn't help. Nor did the fact that Cash for Clunkers and the $8,000 credit for first-time homebuyers caused one-time spikes in new-car and house sales, which fell off sharply after the programs expired.

Our final little secret is that the U.S. is now being forced to live within its means, and that's not fun. For years our country could spend and spend because two bubbles showered companies, consumers, and governments with free money. Who needed to save when stocks were producing almost 20% a year, which they did from August 1982 through the spring of 2000? Or when house prices rose at double-digit rates and you could get cash easily and quickly through a refinancing, second mortgage, or home equity loan? Homeowners raising and spending cash propped the economy for years.

Quantitative easing comes with qualifiers

The closest we're likely to come to free money is the Fed's proposed quantitative-easing moves to buy Treasury securities. Let us show you how it works -- and the problems with it. Let's say the Fed buys $1 trillion of Treasury securities in the secondary market. Out of thin air, it creates $1 trillion in credit balances in the sellers' accounts. The sellers have $1 trillion more cash than they did, increasing the money supply. There is now $1 trillion less of publicly traded Treasuries, which props up their price. By contrast, if Goldman Sachs wanted to buy $1 trillion of Treasury securities, it would have to find $1 trillion of cash to pay for them. Sellers would have $1 trillion more cash than before, Goldman would have $1 trillion less. There would be no increase in the money supply or decrease in the Treasury supply.

If the Fed could buy endless amounts of Treasury securities without any side effects, it would be almost like free money. The securities would cost the Treasury little or nothing in the way of interest, because the Fed turns over its profits -- $53 billion last year, $40 billion in the first half of 2010 -- to the Treasury. So if the Fed buys $1 trillion of 2.5%, 10-year Treasury notes, Treasury's $25 billion annual interest expense is offset by the $25 billion of extra profit the Fed would make, all (or almost all) of which would be turned over to the Treasury. See? Isn't that grand?

There is, however, a problem. The Fed can't do that indefinitely without touching off inflation, debasing the dollar, or both. Markets are bigger and more powerful than the Fed. Consider the reaction of people like veteran Wall Street value investor Hugh Lamle of M.D. Sass to quantitative easing. "It's one thing to do $800 billion once," he says. "But if the federal government is going to print $1 trillion a year for five years, maybe I don't want to be in dollars." A second factor is that long-term rates are already so low that it's not clear how much stimulus you get from cutting them more. It's a big deal to cut interest rates to 5% from 8%. But at lower levels, the result is less dramatic. Do you think the difference between 3% and 2.5% is going to matter? Meanwhile, these ultralow rates are penalizing American savers -- especially retirees relying on CD income to supplement Social Security. They tend to spend all their income, and it's down sharply. That's one reason the economy is weak.

Don't get us wrong, there are plenty of winners in this game -- just not the ones who need help. Cash-rich corporations are issuing billions of dollars of cheap debt for purposes such as buying back stock rather than expanding and creating new jobs. Corporations have record cash on hand but aren't using it to expand in the U.S. Banks, too, are profiting mightily from quantitative easing. They can borrow short-term money for essentially nothing, then buy Treasury securities, knowing that the Fed will support the securities' prices by buying them in the market. Playing the yield curve is easier, less risky, and more lucrative than what the government wants the banks to do: make loans.

Perhaps the biggest problem we have standing in the way of having good times back is housing -- which is an example of how deep-rooted our problems are and how resistant to government programs. Housing was a major source of national wealth for decades, and home equity, however sadly diminished, is still the biggest single piece of wealth many Americans have. That's especially true of lower-income people. No one shouts this from the rooftops, but the federal government and the Fed are doing all they can to prop up house prices. Thanks to the Fed's forcing down long-term rates, fixed-rate mortgages are at record lows. Most of those mortgages come via Uncle Sam. For the first half of the year, 89% of mortgages came from the government-run Fannie Mae, Freddie Mac, Federal Housing Administration, and Veterans Administration, according to Inside Mortgage Finance. That's almost triple the levels of housing's peak years: 31% in 2005 and 30% in 2006.

Even with all that effort, though, housing prices may be stabilizing at levels far below their peak four years ago rather than recovering broadly.

When will house prices get back to where they were? John Burns of John Burns Real Estate Consulting, one of the nation's savviest real estate analysts, invokes the seven-and-seven rule. In previous local-market bubbles, Burns says, "the rule of thumb is seven years down and seven years up" after the bubble pops. Apply that rule to the national market, where the bubble popped in 2006, and we're talking about a sustained recovery starting in 2013, and taking until 2020. That's pretty grim, but probably realistic.

So when are we going to know when things are getting better? They may, in fact, be getting better now, but it's going to take a long time for the wound to heal completely. We need to take care of people who have lost their jobs and lost their hope. But after the midterm elections, when there's going to be immense pressure to adopt everyone's programs, we can't just throw money at everything, searching for magic cures and magic sound bites. If we do, it will take us that much longer to climb out of the hole.