Today, many European countries are facing difficult decisions as a result of their high debt and deficit levels. The US is in a similar situation, as deficits persist and debt levels climb. The cause of these problems is fairly simple: living beyond one’s means. Government spending is much higher than taxes, and this difference is funded with debt.

One of the major differences between Western countries and Asian countries is the welfare state. It is also one of the main reasons the former face high debt levels, while the latter not so much. It could also be a reason why Asia’s growth is set to outpace Western growth over the next decade.

Most European countries offer their citizens free healthcare. Other benefits include subsidized housing, generous state pensions, financial support for low-income groups, and a host of other measures. The US system is less generous, but nonetheless, much of their debt is a result of healthcare subsidies to retired citizens, and low-income groups. As Western countries facing ageing populations, healthcare costs have only one way to go.

The generous government support is funded through fairly high taxation levels. Marginal tax rates for middle class earners can be well in excess of 50%, once all taxes are taken into account. Still, these high taxes do not seem to be enough to fund all social programs. Over the next decade, taxes will have to rise, or government spending must fall.

Which is more likely to occur, tax rises or spending cuts? Well, it will certainly be a combination of both, but it will be mostly spending cuts, and a rollback of the welfare state. Why is this? First, from a political perspective, it is easier to cut spending than it is to raise taxes. Second, if taxes go up too much, it will hurt investment and growth over the long term. Spending cuts won’t have as bad an effect.

A consequence of this is that economic growth in Western countries is likely to be low in the next few years. Government spending is a component of GDP, so cuts in spending directly reduce GDP. Government spending cuts also tend to hit the poorer parts of society the hardest (as lower income groups benefit most from government spending to begin with), so we may expect income inequality to rise.

While the welfare state may be on the way out, it does not mean that economic prosperity must go with it. Cutting spending and reducing debt are as important as putting in the right economic policies to support growth and investment in the future.

Disclosure: I do not hold the currency/commodity discussed in this report.

Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!

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