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.
We said Colin!
Your comments over thge years have always made good sense!
Thanks
Hi Colin:
Great article.
I think that you just agreed with Bernanke and Geithner, is that right.
Your article is clear, but you don’t mention who might win the race to inflation. No doubt there will be some that draw shorter straws than others.
Politically, austerity allows the politicians to blame someone else, and claim victim status for the inflicted.
It seems that in the end, the same people will bear the burden; inflation simply disguises it better.
I still believe in small government, balanced budgets, strict control of money/debt expansion and allowing the market to set interest rates rather than the Fed. If these were adhered to we would never have experienced the GFC in the first place. But these are desperate times. And desperate times call for desperate measures.
Really great succinct article thanks loads
Glad you enjoyed it. Thanks.
Well said and would have loved to read a more detailed insight alluded to with regards to banks and their production of money. Hopefuly, this insightful reading will become a more regular feature of your newsletters. Well done.
Thanks Tim. I will write more on banks and money creation as soon as I find the time.
Sorry Colin, much as I am a fan of yours when it comes to stock and currency forecasts, I have to disagree with your Keynesian prescription. You admit further money printing will lead to a new cycle of inflation, speculative bubbles and financial crises down the road, yet you say the short-term relief from the adverse effects of austerity are worth the trade-off. This seems a knee-jerk reaction. We have to ask ourselves: are we doomed to an existence of going from one crisis to another, each worse than the previous? Will it not all explode at some stage when the current pains of austerity will pale in comparison?
The choice is not between austerity and new debt. It is between a honest and a dishonest financial system. Contemporary monetary policy makers have forgotten the critical function of money as a store of value. Savers and retirees forced into risky gambles and indebtedness in place of security can attest to the devastating effects of constant currency debasement, especially today when real interest rates are lower than the rates of inflation around most of the world.
At the core of the problem lies the US dollar’s role as the global reserve currency driven by national priorities of the US government, priorities that increasingly defy reason. It is the dollar printing that induces other countries to print more of their own currencies in the constant chase of a shifting equilibrium. We need a stable reserve currency free from the influence of any one country, such as a basket of currencies managed by a representative group of developed and emerging economies, pinned to an underlying basis that cannot be expanded at the whim of politicians, like gold. Expecting US policy makers to develop a global sense of financial responsibility is wishful. For sure, currency debasement has taken place historically before the emergence of the dollar, as you have rightly observed. But we were not living in such a financially interlocked world then. If the government of a country chose to abuse its money, people in other countries didn’t have to pay the price.
Inflation only benifits the wealthy and the mobster poiticians, Most of The American people are already to indebt to spend and their wages have not kept up with inflation. America will be like Japan for 20 years due to the policies are the same as Japans QE 1,2,3. The baby boomers are retiring so they do not want to spend the economy will be in deflation no matter how much they print due to the majority do not want more debt and they are retiring and the rest have to little wages to make a difference and cannot handle more debt. So you are wrong there will not be mass inflation as hard as they try and print there way out Japan here we come!!
Don’t under-estimate the power of the printing press. If government borrows and spends enough there will be inflation.
Austerity is not bad but will fail. Inflation is not good but inevitable.
It is not a case of whether inflation is good or bad. Austerity will fail. Inflation will occur — it is the only tool left. If the outcome is inevitable, we should be discussing how best to adapt to this and minimize the side-effects.
The choice has already been made — this is a dishonest system and we are suffering the consequences.
You need a gold-backed reserve currency rather than the dollar. But there are problems. The Swiss did not relinquish their gold standard (in 2004) lightly. They were concerned it would harm their export trade — having an over-valued currency relative to one’s partners.
To the extent policy makers will opt for inflation instead of austerity to save their own necks, I am with you. That is the likely immediate scenario. But how does one adapt to the fallouts? How do ordinary wage-earners prepare for losing their jobs, becoming insolvent and trying to borrow from family and friends who may themselves be under water? Events are evolving rapidly, so there is no question of asking people to build safety nets by way of savings. If they haven’t saved so far, it’s too late already. The tyranny of the present financial system can be overthrown only by popular uprisings. For that to happen, the majority of voters has to suffer intolerable pain. They haven’t reached that threshold yet. Meanwhile, the world will keep lurching from one crisis to another. The Bhagavad Gita says ‘during the time of destruction, one goes against one’s intelligence’, hastening the day of reckoning. Which is perhaps for the good. Why prolong the agony?! Continue the good work, Colin.
It is easier for wage-earners to adapt to higher inflation than to plummeting GDP and mass lay-offs. The consequences of inflation are more long-term and (with self-discipline) may be moderated by a gradual and continuous tightening. Like I said: you have to throw the engine into reverse before the collision — not afterwards.
Remove the capital gains tax on holding precious metals and we will have an “adjustable rate” gold standard by proxy.
Have any other states joined Utah in recognizing gold and silver coins issued by the federal government as legal currency?
Interesting interview with Hugo Salinas Price on how a silver standard could work for GREECE.
http://globaleconomicanalysis.blogspot.ca/2012/06/max-keiser-and-with-hugo-salinas-price.html?utm_source=feedburner&utm_medium=email&utm_campaign=Feed:+MishsGlobalEconomicTrendAnalysis+%28Mish%27s+Global+Economic+Trend+Analysis%29
Hugo Salinas Price: How a silver standard would save Greece
Keiser Report. Skip to 13 minutes into the report: http://youtu.be/Hhi2BBfbZU8
One problem. If Greeks converted their Savings into silver coin that would cause a deflationary spiral. Savings would not be channeled through the financial system into investment, but be parked in silver. The resulting leakage would cause a massive loss in national income.
It is absolutely true that inflation benefits the largest borrowers. And those are governments and central banks. After a period of inflation they can repay their debts with cheaper money than they borrowed.
Especially when you can suppress long-term interest rates. Italy/Spain show what happens when you can’t.
Colin, your comment shows you are a good man, but it’s the comment of a civilian. Governments have more than just fiscal and monetary levers. They also have military levers– and they use them, to achieve economic goals.
To wit:
Europe needs about $3 trillions; the US needs about 4. Billions won’t do.What’s needed are trillions. And there are only three places to get trillions:
In the pockets of citizens via taxes = austerity; If governments do this, they fall. No go.
In the pockets of shareholders = money printing; If governments do that, markets crash. No go.
In the pockets of China = selling half of Europe to them free and clear, because their own citizens won’t let them spend it otherwise. No go.
In the pockets of the richest tycoons– oil suppliers. That’s the only solution.
$30-40 oil, i.e.: Gulf War 3.
If it sounds ridiculous, consider this:
The junk bond recession (1989-1991) ended with Gulf War 1 (Jan 1991), and a 10-year bull market.
The dot.com recession (2001-2003) ended with Gulf War 2 (Mar 2003) and a 5 year bull.
This sovereign debt recession (2008-2011) must end with Gulf War 3, and yet another bull market– which will help re-finance debt, and transfer the austerity from the West to the East– Iran, Saudi Arabia, and Russia.
But they don’t vote here, do they?
Expand your thinking, Colin, and you’ll see that this is indeed what must happen.
Regards,
JE
Canada
I appreciate your view point, but I don’t think the public will buy another war anytime soon. If anything, that is dangerous as global competitors grow bolder and make war inevitable in the long run. If France and Britain had not been war weary in the 1930s, WWII may never have happened.
First they cut holes in the coins.
Second they tried to counterfeit gold
After many tries fiat money appeared, and is currently close to a record to beat the number of years fiat reigned
The printing press had real value
Today the computer does it
The trend for the many is lower salaries and higher prices. I doubt the modern man is any different from the Roman citizen or the middle age man, or the many in the days of fiat. A government of the rich, for the rich, by the rich is the future, but in history that has never set well in the stomach of the masses.
Congratulations Mr. Twiggs; a deadly and penetrating conversation. Neither austerity, nor inflation, nor war (initiated by the rich) can cure this chronic condition of excess. The most difficult task is to cure greed, since no amount of excess can satisfy the desires of greed.——– Hasty attempts will simply make matters worse; like curing a tooth ache with a hand grenade. Mother nature is in charge; “sometimes we get the elevator, and sometimes we get the shaft”, why rush ?
There are only two ways to motivate people: greed (self-interest) and fear (force). Capitalism is built on people pursuing their own self-interest. Socialism is built on force. I would prefer to tolerate the excesses of the former than the latter. Though we do need regulation (force) to curb some of the excesses.
Interesting debate with Conard/Stiglitz on growing income inequality.
OK Colin; but, I’ll stick with my view that humans can rise above a grunt, and the premise “give a little, get a little; give a lot, get a lot”. Love works in there somewhere for me as a motivation and purpose.
I disagree. Asia had a quick painful experience but is now booming again. Whereas somewhere like Japan has printed printed printed and is no closer to a recovery 20 years on
Oh and u can see how well money printing paid off in Zimbabwe..
It would be interesting comparing Asia’s path to recovery with that of Japan. I will do some reading.
But I don’t think a 30% to 40% drop in GDP can be dismissed as “quick and painful”. Imagine the carnage that would cause in Australia.
Why should Wayne Swan trumpet a surplus budget? Have a look at Australia’s GDP numbers, it looks like business as usual. Next year when there is a Federal Govt election Swan will pump prime the economy again as he will have the fiscal ability to do so. Australia is not called the lucky country for no reason.
BJS Australia
What Mr Swan must beware of is that most Australians are not sharing in the boom, they are doing it tough … and waiting to take their revenge at the polls.
Hi Colin I enjoyed your article which raises a question. If QE3 is a forgone conclusion, how will that effect the ratio between the Aussie and the US Dollar? Will the Aussie rally in response or will the slowdown in the China offset this.
Regards
Ron
The Aussie Dollar rose almost 70% from 2009 to 2011, when QE1 and QE2 were implemented. That was largely attributable to the rise in commodity prices: $CRB rose 70% as well. Gold rose +/- 250% over the same period. If QE3 occurs I would rather buy gold. To answer your question:
exactly, Jeff.
and lower cash rate induces price rises and unreal growth. Paper money loses a corner of itself!
strange day: Reserve lowers interest to feed expansion while the GDP has already jumped ahead. Contradiction, what!.
An idea for change right thru is halving land price under housing;
ppp (purchasing power parity) will follow nation al pricing down. Nominal money will return to real value cum all costs lower. .
Oz gains.
The austerity policies redolent are the opposite of what is wanting.
(budget surplus is maniacal).
To spend is to produce. is wanted. more debt well spent is the first cure.
the world has gone crazy
A surplus to pay super in futurwe is the opponent of surplussing.
I’m a Keynesian
ffs
Halving land prices would precipitate another banking collapse.
Brilliant interview with Hugo Salinas Price explains how a silver standard could work to save Greece.
http://globaleconomicanalysis.blogspot.ca/2012/06/max-keiser-and-with-hugo-salinas-price.html?utm_source=feedburner&utm_medium=email&utm_campaign=Feed:+MishsGlobalEconomicTrendAnalysis+%28Mish%27s+Global+Economic+Trend+Analysis%29
Comments from SafeHaven:
JDanaH
The reason I hate the term is that slashing government spending — and just as important, government power (but NOT raising taxes) is the only road to prosperity, not austerity, in the long-term.
ColinTwiggs:
Small government is the long-term solution but we need to recognize that this will take time to implement. If we cut spending now and send the economy into a deflationary spiral, we destroy our capacity to produce. Long-term unemployed and underemployed (graduates flipping burgers) lose skills and idle plant and equipment decay. Increased infrastructure spending will help preserve productive capacity and (if done judiciously) enhance tax revenues. Rather than pay people unemployment benefits, employ them in a productive manner building infrastructure.
‘Small Government’ is simply code for removing centralised power that allows regulation of America’s financial institutions and corporations. If all government decisions are devolved to local coucil level then who will be able to stop the kind of excesses that caused the GFC. Even with a large government the problems were difficult to resist but at least they could be ‘solved’ [‘Were those solutions effective?’ is another issue] after they were discovered. What chance would ‘Small Government’ have at tackling the GFC?
And as an aside, this article has an interesting graph about debt level in the USA in it:
http://www.factcheck.org/2012/02/dueling-debt-deceptions/
Small government and regulation are not mutually exclusive: you can have one without the other.
Hi colin thanks for the artical.
As your average joe blow ,to me the systems become corrupt ,how can it be that a company can be deemed to be to big to fail and be given handouts when it bets the wrong way?Where is the fairness in that system?If you incure a det you pay up. Now you have companies working on the fact that they are to big to fail, so they can do as they please ,and be given hadouts if they make the wrong bet.This needs to be sorted first,companies deemed to big to fail need to be split up, to a size thats not to big to fail.I realise that may affect productivity but better this, than being held to ransom.
Once the systems reset ,we will be able to move forward again.Just my 3 cents worth.
I agree. Break up the TBTF banks by requiring higher levels of reserves, making them uncompetitive.
TBTF companies may be more difficult. First of all, how do you define them? Number of employees? Sales? Net Income? Gross or Net Assets? Strategic industries only? Would Microsoft, Google and Apple qualify as TBTF? What of Walmart? Coca Cola?
Hi Colin
You make some interesting points.
Google is a company with fingers in many pies ,it becomes a problem when it is the only source for crital supply / information.
To combat this, goverments would need to submit contracts ,aimed at incouraging alternative suppliers in those critical areas.This unfortunately could lead to reduced productivity ,but in the long term provide a more sustainable system.
I personaly wouldn’t class coke cola as a critical supplier, though others may disagree ie dentists. If they ventured into staple foods and were the only supplier, that would be different situation.
Companies are there to make money ,and the maximum profits come from being the the sole supplier..
It isn’t an easy situation to solve, as the landscape is constantly changing.. hopefully goverments can keep up.
Sorry if i took your thread off track.:)
cheers Ian