Last night’s 500-point fall on the Dow Jones and shocking 6.6% fall by the S&P 500 was not primarily caused by S&P’s downgrade of US debt. That debt itself continues to rise in price, not fall.

The Dow has corrected 15% and the ASX 200 by 18% because investors have discovered the limitations of artificial stimulus on the economy. The Great Reflation has run its course but the patient is fading.

S&P’s gratuitous and probably self-serving action on the weekend merely highlighted the problem that is staring everyone in the face: America has reached its debt limit and must start cutting back just as the economy is apparently getting weaker. Something similar is happening in Europe and Australia.

Ironically it is politics, not economics, that is the source of the problem.

The bond market is telling the US Treasury that it can, and should, continue to borrow but it’s the right-wing politicians holding the balance of power in the House of Representatives that have demanded fiscal consolidation now — supported by S&P.

The Federal Reserve, having closed off QE2, is mute, balance sheet bloated like the stomach of a character from the film La Grande Bouffe. The market is pleading for QE3, but so far nothing.

Likewise Europe has stimulus ammunition available, but politics stands in the way, along with Jean-Claude Trichet, the famously tight president of the European Central Bank.

Germany continues to enforce fiscal and monetary orthodoxy when the logic of monetary union demands that it and the other surplus states must stimulate demand to offset the austerity programs being imposed on the peripheral states by bond markets and the EU and IMF bureaucrats.

The ECB has said it will buy Italian and Spanish bonds, but it’s too little, too late. What’s required now is a European version of quantitative easing, flooding the eurozone with cash: any intervention now must be massive to convince markets that the authorities are serious.

Politics is also imposing fiscal consolidation on Australia at precisely the wrong time.

The Australian government is tightening fiscal policy by about 2% of GDP to meet an unnecessary, politically constructed deadline of 2013 for returning to surplus, with one quarter of negative GDP already under our belt and another one threatening.

No wonder sharemarkets are falling and gold is at $US1700. It seems the past three years of grinding tentative recuperation from the crisis that came from the massive injection of fiscal and monetary adrenalin in late 2008 and early 2009 have come to nothing. The patient is slipping back into a coma.

*This article was originally published at Business Spectator