In recent weeks, the stock market has made a run that has most Americans asking, “Are we out of The Recession yet?” Investors seem to think so, and the Fed has contributed to the optimism. It recently released a report that claims the outlook has “improved modestly” and the economy is contracting at a “somewhat slower pace.” Economists and investments managers have been quick to jump on board the happy talk express and announce that the recovery is just around the corner.

If there’s one thing the Obama administration believes, it’s this: the key to slowing the economic downswing is to manage the public’s perception of the problem.

Take the bank stress tests, for example. In February, after Tim Geithner made his disastrous announcement of a vague plan to rescue the banking system, the markets went into free-fall. The White House realized that merely announcing their earnest intentions to fix the problem was not enough. They had to manufacture an event that would reassure investors.

Business news in this country is all about periodic events and how the stock markets react to those events. When the Labor Department issues its monthly report on unemployment, it’s an event that triggers a rash of buying and selling on the stock market. Investors place their bets, in other words, on whether the news is going to be good or bad. The White House has come to understand that these events are important to Wall Street, and so it has devised the bank stress tests as a means to urge investors to place their bets in favor of the banking system.

Many economists have proposed that the best way to stabilize the US financial system would involve nationalizing the banks, taking their stock off the NYSE, and removing them from the burden of the daily, hourly, even minute-by-minute tyranny of their shareholders’ bets. The current under-capitalization of banks is obviously exacerbated by the precipitous drop in their stock prices: the lower their stock prices fall, the less capital banks have and the harder it is for banks to borrow money at advantageous interest rates to cover their operations.

Hence, the notion that, by nationalizing the banks, we take away the constantly shifting sand beneath the banks’ balance sheets. Shareholders, of course, would lose their entire investments in bank stocks, but the value of most of those stocks has already dropped by 95 percent in the past year, so shareholders really don’t stand to lose much more at this point.

Barack Obama, however, has announced that he will never nationalize any US banks. Having closed the door on the most sensible approach to stabilizing the system, he’s committed himself to the only other approach available: find some way to push up the price of banks’ stocks.

Hence, the White House concocted the stress tests, which are pure advertising, with almost no substance to support them. For example, the stress tests assume that unemployment will hit 10.3 percent by the end of 2010, but the Labor Department just announced that unemployment has already hit 8.9 percent in April. Most economists now agree that unemployment will hit 10 percent or higher by the end of 2009, and layoffs are expected to continue throughout 2010.

Another example: some banks are already reporting larger commercial real estate loan losses than were assumed under the worst case scenario in the stress tests. Clearly the tests were designed to be a very low bar. Since the Treasury Department consulted with Wall Street banking executives on the design of the tests, we shouldn’t be too surprised.

In addition to being worthless, the tests are highly misleading. They emphasize losses on loans that banks have made to customers and then kept on the banks’ books. The tests have paid no attention to losses on derivatives and mortgage-backed securities–the “toxic assets” which are at the root of the current economic crisis. For the Treasury to ignore the impact of these investments on bank balance sheets now, while running these tests, is a sign that the Obama administration is content to perpetuate the grossly lax regulation of the past decade. What’s required is exactly the reverse: the system can’t and won’t stabilize until stronger regulations governing these opaque investment vehicles are in place.

Meanwhile the real economy is still in an ever deepening slump. The economy shrank by 6.1 percent in the first quarter of this year (January through March), while economists had predicted a fall of 4.7 percent. Homebuilding and construction shrank by 38 percent, the largest fall since 1980. Business spending fell by the highest amount since the 1950s. Exports fell 30 percent, their worst showing since 1969. Even the government sector trimmed spending, in spite of the Economic Stimulus Bill passed by Congress (a sign that state and local governments are really suffering).

We’re still seeing declines in credit, falling home prices, increased bankruptcy filings and foreclosures, and unemployment increases in all metropolitan areas tracked by the Labor Department. The fact that April’s declines are slightly less than March’s or January’s is not significant of anything, except that the downturn is continuing.

One group of investors that hasn’t been fooled by the stress tests is foreign governments, particularly China and Japan. For years now, the US has relied on Asian investors to finance the deficit by buying US Treasury bonds. Recently, China’s diplomats made noises about the rising US deficit and lack of transparency in our financial system, and how this is eroding China’s investment in our country. This was China’s way of saying that they won’t continue to pour cash into our system unless we clean up our act. Unfortunately, the Obama administration ignored these warnings.

So last week’s auction of 30-year US Treasury bonds was much weaker than expected. With not enough buyers wanting bonds, the US government watched as bond prices fell and interest rates rose, in spite of the fact that the Federal Reserve is buying up long-term US Treasury bonds to keep interest rates low. Asian investors are no longer willing to step in and rescue us. Inflation and higher interest rates may be just around the corner, and nothing would kill a nascent recovery quicker, or plunge us into a deeper downward spiral faster, than inflation on top of a recession.

By closing off the most direct route to stabilizing the system–nationalizing big banks and imposing a stronger regulatory apparatus–the Obama administration is risking a train wreck. Happy talk might obscure the problems for a while, but it can’t change the underlying reality.