Nominal GDP targeting puts your savings in the crosshairs.

Flummoxed by a recession that has proven resistant to fiscal and monetary stimulus, the nation’s financial pundits have hatched a new policy—or at least a new catchphrase—that some are claiming will finally fix the ailing, slow-growth U.S. economy.

It’s called nominal GDP targeting, and the idea might seem too obvious to be profound: rather than pursue its twin mandates of limiting inflation and boosting employment, the Federal Reserve should focus on raising the nation’s nominal gross domestic product (GDP), a broad measure of economic growth, to a target high enough to get the country moving again.

Prominent advocates of nominal GDP targeting include Christina Romer, former chair of President Obama’s Council of Economic Advisers, and Goldman Sachs—yes, the infamous vampire squid.

That roster should be enough to give one pause, but the policy itself is rife with questionable assumptions and undisclosed risks. Rather than being the innovation its champions claim, targeting nominal GDP simply extends dubious policies further into uncharted territory.

If we scrape away the econo-speak, we find that nominal GDP targeting is simply code for “let’s stop worrying about inflation and crank up the printing press, baby.” While its proponents are coy about exactly what they’re suggesting the Fed do after targeting nominal GDP growth of, say, 5 percent per year, the basic idea is to flood the economy with even more low-interest money.

The hidden assumption here is insidious: once inflation kicks up—and at 3.9 percent it is already well above the Fed’s “comfort zone” of 3 percent—then Americans will stop trying to save or pay down debt and will instead go back to borrowing and spending freely.

In other words, instead of Americans acting prudently to lower their unprecedented levels of debt and build some capital, the advocates of targeting GDP want us to go back to the go-go days of the housing bubble and borrow and spend more, more, more, all because they believe the key problem is lack of consumer demand.

Rather than explore why demand has declined, GDP targeters want to bulldoze American consumers back into taking on more debt. Their plan is twofold: one, keep interest rates so low that savers are punished, and two, crank up inflation so that households are forced to spend money before it loses value.

To say this is perverse is an understatement. If we consider the fundamentals of capitalism—something few financial pundits and Wall Street types seem to bother with—we start with capital, i.e., cash savings that can be invested in productive enterprises. No capital, no capitalism. Those promoting GDP targeting are thus profoundly anti-capitalist, as their basic idea is to punish capital formation and reward unproductive debt that fuels consumption, not investment.

This flies in the face of both common sense and various studies that find long-term prosperity flows not from debt-fueled consumption but from investment and the resulting rise in productivity.

Proponents also seem blind to what is painfully obvious to everyone else: Americans are already so heavily indebted, they can’t afford to take on more debt, even at low rates of interest. Consumers are pressed against the wall by rising inflation, and even many who could borrow more prefer to pay down debt instead.

The GDP-targeting model is coy about what happens after the Fed succeeds in stoking inflation. It’s important to note that its advocates are talking about nominal GDP, not real GDP. The first is the headline number—how much the economy grew last year—while real GDP is the nominal GDP minus inflation.

A 5 percent nominal GDP with an inflation rate of 4.5 percent yields real GDP growth of only 0.5 percent. It’s entirely possible to get inflation really fired up and have a 6 percent nominal GDP and a 7 percent inflation rate—in other words, a negative growth rate that is masked by the positive nominal GDP.

Those cheerleading GDP targeting blithely assume that the Fed can easily suppress inflation by tightening interest rates once the economy is firing on all cylinders again. But history suggests that once inflation expectations have notched higher in the collective awareness, they are exceedingly difficult to reverse. Indeed, former Fed chairman Paul Volcker had to raise interest rates to 18 percent in 1982, laying waste to the auto and housing industries, to reverse the inflation expectations that had taken hold in the late 1970s.

The nightmare scenario that proponents don’t mention is one in which the Fed unleashes a torrent of money into the economy, inflation leaps up, but employment stays subdued. Then, to fight the roaring inflation it created to boost the nominal GDP, the Fed has to raise rates—not by a quarter point, but by a lot, and for a long time. Not only would that tightening suffocate the debt-based “growth”—actually, more inflation than actual growth—it would also trigger new declines in employment. We would end up with the worst of all possible worlds: high inflation, high interest rates, and rising unemployment.

The entire notion that incentivizing more borrowing will lead to growth is suspect. Indeed, if we divide real GDP by the increase in debt (both public and private), we find that the return on debt has been declining for decades and has now fallen to a negative number: in effect, we’re borrowing trillions of dollars—roughly 11 percent of GDP on the federal ledger—each and every year just to stay even.

Each additional dollar of debt added about 70 cents to GDP in 1970. By the early 1990s, the yield had fallen to 50 cents, and when the housing bubble was largest in 2006 it was less than 30 cents. With the explosion of federal debt to bail out the banks and provide fiscal stimulus, we’ve reached a point where real GDP has barely budged from pre-recession 2007 levels, yet we’ve poured roughly $6 trillion in new federal borrowing into the economy.

According to the Bureau of Economic Analysis’s calculations—and not everyone agrees that they measure the consumer price index accurately—the 2011 U.S. GDP has finally reached the GDP level of late 2007. Including the Federal Reserve’s $2 trillion expansion of its balance sheet and off-balance sheet federal borrowing for wars and bailouts for AIG, Fannie Mae, etc., we have borrowed and spent an extraordinary amount of money for essentially no growth in GDP. (And public borrowing is not the only problem: consumer debt rose from $2 trillion in 1984 to $14 trillion in 2008.)

Since flooding the economy with all that borrowed money resulted in a “jobless recovery” and nil real GDP growth, what makes the cheerleaders of nominal GDP targeting believe that the next $10 trillion in debt will work any better than the first $10 trillion did?

The advocates of GDP targeting are just as data-deficient in their unstated assumption that GDP growth is strongly correlated to job growth—that is, that a rise in real GDP translates into strong job growth. If we look at the past four years, we find the correlation is extremely weak. For example, in the third quarter of 2009, the economy was growing at a rapid 5 percent annual clip, but jobs were still being lost. By mid-2010, employment had perked up, but GDP growth had slipped to an anemic 1.7 percent.

The problem with targeting GDP is not just the reality-distortion field required to believe it would work, but also what the proponents dare not ask: what if the U.S. economy is facing structural headwinds that can’t be fixed by more borrowing and more Fed goosing of financial markets (i.e., “quantitative easing”)? What if the fundamental problems are precisely what the GDP targeters propose as solutions: indebtedness, zero-interest rates, rising inflation, and a clueless Federal Reserve that only has two levers to pull—Fed funds rate and quantitative easing—and has been yanking on them for four years?

The supporters of targeting GDP dare not consider this, because they would be revealed as not only lacking answers but also lacking a context for grasping the question.

The conventional fixes haven’t worked; they’ve only deepened the nation’s debt hole and rendered our financial system exquisitely dependent on constant Federal Reserve intervention and “easing.”

We have the proper context, and it’s called capitalism—something few in the halls of power seem to know about. Capitalism works by rewarding capital formation and productive investments. That requires a healthy rate of interest, not a zero rate that only encourages malinvestment and unproductive speculation. With a zero rate of interest, banks have trouble making money on their deposits. Hmm, isn’t the Fed trying to save the banks? Then why is it destroying their ability to earn a return?

Capitalism works by enabling the liquidation of insolvent lenders, enterprises, and households and letting the market discover the price of assets. Instead of allowing that, the Federal Reserve and federal regulators have enabled the masking of insolvency via illusory (marked-to-fantasy) asset valuations and bailed out banks that should have been liquidated long ago.

Rather than continuing to advocate policies that have demonstrably failed on a grand scale, GDP targeters would be better served by studying the forgotten basics of a system that does work: Capitalism with a capital C.

Charles Hugh Smith is the proprietor of the Of Two Minds blog and author of An Unconventional Guide to Investing in Troubled Times.