Budget Cuts?

As violent protests erupted outside, the leaders of the world's largest economies plotted the future course of the global economy at this weekend's G20 summit. So what was decided? Well, according to various reports in the mainstream media, it was the "deficit hawks" who got their way. Apparently the consensus of the G20 meetings was that a round of tough budget cuts is the medicine that the world economy needs. In fact, the G20 leaders all pledged to cut their respective budget deficits in half by 2013. Canadian Prime Minister Stephen Harper, one of the key advocates of budget cuts, said that the G20 nations need to walk a "tightrope" between stimulating their economies and debt reduction. But as the largest economies around the globe transition from reckless government spending to budget reductions and austerity measures, what is that really going to mean for the world economy?

Well, the truth is that as good as "budget cuts" sound, they can have some very nasty short-term side effects.

You see, there is no getting around the fact that whenever governments spend more money it is good for economic growth. The problem is that a large number of governments around the globe have been consistently spending way beyond their means for decades and now they find themselves up to their eyeballs in debt.

The exploding sovereign debt levels around the globe are not sustainable by any definition, and so it was undeniable that something had to be done.

In fact, European Commission President José Manuel Barroso put it quite succinctly during the G20 meetings in Toronto when he told the press the following....

"There is no more room for deficit spending."

The reality is that nations such as Greece, Spain, Portugal and Italy are already on the verge of default. Japan has accumulated so much debt that it makes headlines almost constantly in the newspapers over there. The exploding U.K. debt was one of the key factors that enabled the Conservatives to take power in the most recent election.

But nobody has more debt than the United States. As of June 1st, the U.S. National Debt was $13,050,826,460,886.97. The U.S. government has accumulated the most colossal mountain of debt the world has ever seen and it is exploding at a rate that is breathtaking.

So, yes, the largest economies of the world have a major problem with government debt.

But are budget cuts and austerity measures the correct solution?

It depends who you ask.

The reality is that the U.S., the U.K. and many of the other most powerful economies in the world now find themselves between a rock and a hard place.

If they continue recklessly going into debt their economies will continue to be stimulated (at least to some degree), but interest expenses will continue to spiral upwards and borrowing costs will go through the roof as credit ratings fall. In the end, nation after nation would end up defaulting and the world financial system would crash hard.

However, if the G20 nations actually do implement the hard budget cuts that are necessary to get their debts under control, it will suck a ton of money out of the system and could send the already vulnerable global economy into a devastating deflationary depression.

The truth is that neither option is a good option.

Either path is going to contain a good amount of economic pain.

So what do you do when there is no good solution?

Stephen Lewis of Monument Securities recently argued that the path of "fiscal stimulus" has been totally played out and so there is no good reason to continue to go down that path....

"Growth could be negative again as soon as the fourth quarter. There is no easy way out since fiscal stimulus has already been pushed as far as it can credibly go without endangering US credit-worthiness."

However, Chris Whalen, a former Federal Reserve official and now head of Institutional Risk Analytics says that unless the printing presses are quickly cranked up again we are definitely headed for deflation....

"The party is over from fiscal support. These hard-money men are fighting the last war: they don't recognise that money velocity has slowed and we are going into deflation. The only default option left is to crank up the printing presses again."

So what is the right answer?

For now, G20 leaders have decided that budget cuts and austerity measures are the right answer.

Not that Barack Obama and U.S. Federal Reserve chairman Ben Bernanke didn't fight behind the scenes for additional "stimulus" for the world economy.

You see, when it comes to "Helicopter Ben", his first instinct is to always pump more money into the economy. In fact, according to one major U.K. newspaper, U.S. Federal Reserve chairman Ben Bernanke has been fighting an intense behind the scenes war for control of U.S. monetary policy. Bernanke is reportedly frightened that the U.S. could be headed for a deflationary spiral and has been pushing the idea of a fresh injection of money into the U.S. economy.

But for now Bernanke has lost. Barack Obama has joined the other leaders of the G20 in promising to cut their budget deficits by 50 percent by 2013.

Not that we are actually going to see that happen.

We all know how reliable Barack Obama's promises are. He was busy breaking his 2008 campaign promises before he was even sworn in.

And the day will come when Barack Obama needs to turn the economy around in order to win some votes, and when that day arrives the temptation to "stimulate" the economy with some more government spending will prove irresistible.

But for the moment, Obama is lining up with the other G20 leaders and is swearing that he is going to get spending under control.

That should settle world financial markets down for the moment, but the reality is that as all of the major economies around the world suddenly see a dramatic reduction in government spending, a substantial economic slowdown will be inevitable.

When the world economy slows down, unemployment will spike, the global real estate mess will get even worse and "austerity riots" could even break out in many areas of the globe.

So at some point, the pendulum will once again swing back towards "stimulus" and world leaders will indulge their debt addictions once again. But that will only make the long-term global economic problems even worse.

The truth is that the entire world economic system is broken. It is built on a fraudulent pyramid of debt, derivatives, central banking and paper money that is doomed to fail. But world leaders will continue to keep it alive for as long as they can.

Right now their big solution is to get all of the major industrialized nations to agree to huge budget cuts. These budget cuts, if they are actually implemented, are very likely to lead to a severe economic slowdown and potentially even a deflationary depression.

But continuing on the path that the G20 leaders were on would have resulted in a wave of sovereign defaults and hyperinflationary meltdowns.

So the G20 leaders have decided to change course and they are hoping that they can navigate the economic minefield ahead and bring our economies through all of this okay.

But in the end they are going to fail.