Austerity decimated Asian economies during their 1997/98 financial crisis and similar measures have failed to rescue the PIIGS in Europe 2012. David Cameron's austerity measures have also not saved the UK from falling back into recession. So why is Wayne Swan in Australia so proud of his balanced budget? And why does Barack Obama threaten the wealthy with increased taxes while the GOP advocate spending cuts in order to reduce the US deficit? Are we condemned to follow Europe into a deflationary spiral?

How Did We Get Here?

First, let's examine the causes of the current financial crisis.

Government deficits have been around for centuries. States would borrow in order to finance wars but were then left with the problem of repayment. Countries frequently defaulted, but this created difficulties in accessing further finance; so governments resorted to debasing their currencies. Initially they substituted coins with a lower metal content for the original issue. Then introduction of fiat currencies -- with no right of conversion to an underlying gold/silver standard -- made debasement a lot easier. Issuing more paper currency simply reduced the value of each note in circulation. Advent of the digital age made debasement still easier, with transfer of balances between electronic accounts largely replacing paper money. Fiscal deficits, previously confined to wars, became regular government policy; employed as a stealth tax and redistributed in the form of welfare benefits to large voting blocks.

Along with fiscal deficits came easy monetary policy -- also known as debt expansion. Lower interest rates fueled greater demand for debt, which bankers, with assistance from the central bank, were only too willing to accommodate. I will not go into a lengthy exposition of how banks create money, but banks expand their balance sheets by lending money they do not have, confident in the knowledge that recipients will deposit the proceeds back in the banking system -- which is then used to fund the original loan. Expanding bank balance sheets inject new money into the system, debasing the currency as effectively as if they were running a printing press in the basement.

The combination of rising prices and low interest rates is a heady mix investors cannot resist, leading to speculative bubbles in real estate or stocks. So why do governments encourage debt expansion? Because (A) it creates a temporary high -- a false sense of well-being before inflation takes hold; and (B) it debases the currency, inflating tax revenues while reducing the real value of government debt.

Continuous government deficits and debt expansion via the financial sector have brought us to the edge of the precipice. The problem is: finding a way back -- none of the solutions seem to work.

Austerity

Slashing government spending, cutting back on investment programs, and raising taxes in order to reduce the fiscal deficit may appear a logical response to the crisis. Reversing policies that caused the problem will reduce their eventual impact, but you have to do that before the financial crisis -- not after. With bank credit contracting and aggregate demand shrinking, it is too late to throw the engine into reverse -- you are already going backwards. The economy is already slowing. Rather than reducing harmful side-effects, austerity applied at the wrong time will simply amplify them.

The 1997 Asian Crisis

We are repeating the mistakes of the 1997/98 Asian crisis. Joseph Stiglitz, at the time chief economist at the World Bank, warned the IMF of the perils of austerity measures imposed on recipients of IMF support. He was politely ignored. By July 1998, 13 months after the start of the crisis, GNP had fallen by 83 percent in Indonesia and between 30 and 40 percent in other recipients of IMF "assistance". Thailand, Indonesia, Malaysia, South Korea and the Phillipines reduced government deficits, allowed insolvent banks to fail, and raised interest rates in response to IMF demands. Currency devaluations, waves of bankruptcies, real estate busts, collapse of entire industries and soaring unemployment followed -- leading to social unrest. Contracting bank lending without compensatory fiscal deficits led to a deflationary spiral, while raising interest rates failed to protect currencies from devaluation.

The same failed policies are being pursued today, simply because continuing fiscal deficits and ballooning public debt are a frightening alternative.

The Lesser of Two Evils

At some point political leaders are going to realize the futility of further austerity measures and resort to the hair of the dog that bit them. Bond markets are likely to resist further increases in public debt and deficits would have to be funded directly or indirectly by the central bank/Federal Reserve. Inflation would rise. Effectively the government is printing fresh new dollar bills with nothing to back them.

The short-term payoff would be fourfold. Rising inflation increases tax revenues while at the same time decreasing the value of public debt in real terms. Real estate values rise, restoring many underwater mortgages to solvency, and rescuing banks threatened by falling house prices. Finally, inflation would discourage currency manipulation. Asian exporters who keep their currencies at artificially low values, by purchasing $trillions of US treasuries to offset the current account imbalance, will suffer a capital loss on their investments.

The long-term costs -- inflation, speculative bubbles and financial crises -- are likely to be out-weighed by the short-term benefits when it comes to counting votes. Even rising national debt would to some extent be offset by rising nominal GDP, stabilizing the debt-to-GDP ratio. And if deficits are used to fund productive infrastructure, rather than squandered on public fountains and bridges-to-nowhere, that will further enhance GDP growth while ensuring that the state has real assets to show for the debt incurred.

Not "If" but "When"

Faced with the failure of austerity measures, governments are likely to abandon them and resort to the printing press -- fiscal deficits and quantitative easing. It is more a case of "when" rather than "if". Successful traders/investors will need to allow for this in their strategies, timing their purchases to take advantage of the shift.