Jan. 7 (Bloomberg) -- After a year of denying the U.S. economy was in recession, the herd has turned and is charging full speed in the opposite direction. Now there’s no chance we’ll ever get out of this mess.

The financial system is broken.

Banks aren’t lending.

Housing supply exceeds housing demand.

The Federal Reserve has no tools left.

Consumers are tapped out.

The unemployment rate is soaring.

All of these arguments are true to some degree, and economists are hard-pressed to find any drivers of economic growth.

That’s almost always the case. Recession tends to make the future look bleak in the same way an expanding economy inspires confidence.

The sentiment cycle is as predictable as the Earth’s orbit around the sun. In the stock market, sentiment is considered a contrarian indicator. If money managers are all bearish, it implies that everyone who needs to sell has sold, making way for a rebound in equity prices.

We could probably construct a similar indicator for economic sentiment and the business cycle.

This isn’t to say I can see a way out of the current contraction or identify a magic bullet -- the government’s proposed fiscal stimulus, for example -- that could pull us out of the slump.

Ebb and Flow

“You never can,” says Jim Glassman, senior U.S. economist at JPMorgan Chase & Co. “It always seems as if spending is in a death spiral when businesses turn cautious. Then, out of the blue, it stops falling and begins to grow again just because the stock of productive capacity is getting close to desired levels.”

This inherent dynamic as described by Glassman -- it goes down, it stops going down, it goes up -- sounds like something out of Chauncey Gardiner, the simple-minded hero of Jerzy Kosinski’s “Being There.” But it’s true nonetheless.

“What about the Great Depression?” I can hear you ask. We all know how well that worked out. It went down, it went down, it went down some more.

The Great Depression witnessed a confluence of policy errors. The government enacted protectionist trade laws. It increased taxes and imposed lots of new ones. The Fed allowed a record number of banks to fail and the money supply to contract by a third. The central bank raised reserve requirements in 1936-1937, nipping the mid-1930s it-went-up and turning it into another it- went-down, according to Milton Friedman and Anna Schwartz.

And those are just the big mistakes.

Giant Whirring Sound

Fed Chairman Ben Bernanke is working hard to avoid a replay of the 1930s, honoring a commitment he made to Friedman and Schwartz, authors of “A Monetary History of the United States,” on Friedman’s 90th birthday in November 2002.

“I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again,” Bernanke said.

So far, he has been doing a good job. The Fed increased bank reserves more than 600 percent in November 2008 compared with a year earlier. That’s “10 times faster than the rate at which the Fed was doing so in 1934,” says Paul Kasriel, chief economist at Northern Trust Corp. in Chicago.

To date, banks have elected to hold most of that increase as excess reserves, on which they now earn interest. That won’t last forever. At some point, banks will start to use those reserves, or raw material, to make loans and buy securities, increasing the broad money supply in the process.

Even if private credit demand is tepid and credit quality is a concern, banks can always lend to the U.S. government, which has embarked on a borrowing binge. The steep yield curve provides the incentive to borrow short, lend long.

Manufacturing Inflation

Under the circumstances, “Do you really think deflation is a likely outcome over the next few years?” Kasriel says.

Even in the mid-1930s, with the U.S. unemployment rate at more than 20 percent and more excess capacity than policy makers knew what to do with, the consumer price index “increased by 3.5 percent, 2.6 percent, 1 percent and 3.7 percent in 1934, 1935, 1936 and 1937, respectively,” Kasriel says.

This isn’t your father’s Depression, even though the herd is behaving as if it is.

The spread between investment-grade bonds and Treasuries, which were “as tight as they get seven years into the expansion, are wildly wide now because there was one data point -- the Great Depression -- where it didn’t pay to buy,” says Bob Barbera, chief economist at ITG Inc., a New York brokerage. “The herd mentality has no ability to see the top or the bottom.”

That doesn’t mean a recovery, whenever it arrives, will be problem-free. Many of the forces that inflated a housing bubble that ended in a bust that gave way to a recession are either back for a rerun (easy money) or implicit policy objectives (increased consumer borrowing and spending; greater allocation of capital to housing).

Or, as Chauncey Gardiner would say: It goes up, it goes down.

(Caroline Baum, author of “Just What I Said,” is a Bloomberg News columnist. The opinions expressed are her own.)

To contact the writer of this column: Caroline Baum in New York at cabaum@bloomberg.net.

Last Updated: January 7, 2009 00:01 EST