The IMF’s Global Financial Stability Report, released Wednesday, said global financial stability had improved in the last six months. They must be the only people who think so. In reality, the U.S. budget deficit has widened in spite of the economic recovery, the financial services sector is undertaking ever more preposterous deals, storing up trouble for the future, the Icelanders have demonstrated the joys of not paying their bills and U.S. consumer saving is once again heading towards zero. The two year period of “debt deflation” has not deflated the global level of debt, merely shifted it around a bit, and it is now clear that we will shortly have it all to do again.

It is frequently forgotten how extreme were the financial and economic policies adopted to address a fairly standard financial crisis. Carmen Reinhart and Kenneth Rogoff’s magisterial 2009 book “This time is different” demonstrated that recessions triggered by financial crisis are generally more severe and longer lasting than normal, so it is not surprising that times are still hard, 30 months after the crisis. However, banking, fiscal and monetary authorities in the U.S. and elsewhere panicked when the crisis hit, forgetting three centuries of history, and threw the entire resources of the modern state at the short-term problem.

Fiscally, it is now clear that the United States’ record has been uniquely profligate. According to IMF figures, the U.S. bank bailout has cost only 3.4% of GDP, compared with Germany’s 10.7% of GDP, yet the U.S. budget deficit for calendar 2011 is estimated at 10.9% of GDP compared to Germany’s 2.3%. (Given that the principal asset problem lay in U.S. housing, and that Germany had no comparable housing bubble, it can also be concluded that German banks were uniquely stupid!)

Outside the Civil War and World War II, the United States has never run deficits of anything like this size. The 1979-82 recession was comparable to this one in length and severity, yet the budget deficit peaked at 6.3% of GDP in 1983, by which time the U.S. economy was growing rapidly. U.S. monetary policy has however been even more extreme than fiscal policy. The zero Federal Funds rate, prolonged now for 2½ years, is not as negative in real terms as short term rates became on a number of occasions in the 1970s. Yet the psychological effect of a zero nominal interest rate is incalculable. It prevents savers from receiving any return on their money, unlike in the 1970s when their nominal returns were quite substantial.

You can argue all you like that the more negative real returns of the 1970s represented easier money, yet the effect on savers of receiving no return on their savings, or on borrowers of having to pay almost nothing for their money is huge. Savings are depressed as simple folk give up altogether, while speculative house building continues in areas like the Virginia suburbs, in the knowledge that there will always be buyers with more money than sense. After all, you can’t expect the likes of trial lawyers and lobbyists to understand the finer points of economics such as what interest rates are for; if they learned “economics” at all they learned Keynesianism, and this ignorance has in no way hindered their unpleasant careers. Money illusion, a Keynesian boon to over-leveraged borrowers and unscrupulous employers, has economically malign as well as politically attractive effects.

The effects of ultra-easy money are everywhere. Notoriously, it has reduced the U.S. savings rate close to zero, while shrinking capital cost differentials between the U.S. and emerging markets, thus effectively de-capitalizing the U.S. economy. This week an even more startling effect swam into view – if interest rates were at normal levels Donald Trump would not be leading the polls for the Republican nomination, he would be struggling to avoid bankruptcy in his overleveraged real estate and casino empire, which almost came to grief in the tight money conditions of the early 1990s. In Trump’s case, both real estate and casino gambling have been immeasurably helped by 16 years of cheap money — simple folk believe they can get rich by playing the slots, just as Wall Street traders enrich themselves by leveraged bets.

At this point, it is becoming clear that the period of “debt deflation” which Reinhart and Rogoff forecast would be needed before the U.S. and global economies could expand again on a healthy basis has been nothing of the kind. Deflation has been nowhere to be seen, while debt, far from being paid off, has simply been transferred from the housing sector to the staggering governments and the unfortunate taxpayers of the world. The example of Japan since 1990 shows that no good can come of this; small business is increasingly starved of investment capital as banks find easier ways to make money, generally by taking on astronomical quantities of government bonds and funding them at a profit through the short-term markets.

Rather than deflation, we are currently experiencing a rapid increase in inflation. Each month’s statistics show an acceleration in the pace of inflation. Producer prices have been increasing at an annual rate of 10.9% over the last six months, which suggests pretty strongly that we shall soon see a similar rate of increase in consumer price statistics. However this time, unlike in the gentlemanly 1970s, the excessive expansionism of fiscal and monetary policy will prevent inflation from being halted at or just above the 10% level, but will instead produce inflation rates much higher than that.

Apart from producing demands for Ben Bernanke to be given the same 25-years-without-the-option treatment that a public desire for revenge meted out to Enron’s unfortunate Jeff Skilling, this surge in inflation will have two effects. In the very short run, it will greatly alleviate the burden of debt on both consumers and governments, producing a genuine bottoming out in the housing market, a real improvement in consumer balance sheets and an apparent improvement in the U.S. government’s solvency.

This has happened before: in Britain in the 1970s inflation peaked in 1975 at 25%, preventing the Great Housing Crash of 1973-77, otherwise inevitable, from ever taking effect. Within four years of the 1973 peak in house prices, inflation, mostly reflected in personal incomes, had allowed incomes to catch up with house prices. This caused the housing market to turn around and enter another period of boom. It also convinced the British public that housing was a one-way bet, to the great detriment of future economic performance. Finally, it de-capitalized the British banking system (for all the winners from inflation, there had to be offsetting losers) making it easy prey for Wall Street’s sharks when the British markets were foolishly turned into a “level playing field” in 1986 before the banks had time to recover.

In today’s world economy, the losers from an unexpected burst of inflation are not primarily the banks – fortunately for the world’s taxpayers, who would have to bail them out again. Instead the losers are the major investors in dollar debt – hedge funds, Middle Eastern potentates and Asian central banks. There could not be an economically less damaging collection of losers – except that Middle Eastern and Asian losers who have been scammed through wild dollar inflation and currency depreciation will find some doubtless unpleasant way of obtaining their revenge.

The blissful phase in which interest rates in the U.S. and elsewhere are far below the inflation rate will not however be long-lived, although doubtless a desperate Bernanke and his hangers-on will try and prolong it as far as possible. At some point, probably around the time reported inflation passes 20% per annum, the Treasury bond markets, the politicians and the public as a whole will panic, seeing the possibility of a Weimar-style collapse. If this happens at an inconvenient point in the 2012 electoral cycle (or if the present incumbents are encouraged by unexpected electoral victory) little will be done and hyperinflation will set in. That would solve the debt problem, all right, but wipe out the U.S. capital base altogether. At that point there would no longer be any reason why U.S. living standards should exceed those of the competent Chinese, and U.S. wage levels would collapse through inflationary destruction of their purchasing power to around those pertaining in China – the backward parts of China, not the booming bits.

Since the United States is, like Australia, a lucky country, it is however more probable than not that steps will be taken to avoid this ghastly fate. They will involve a Federal Funds rate that is far above the rapidly accelerating level of inflation – say 50% — and long-term bond rates also above the inflation rate, at about 25% or so. Any benefit the U.S. government and individual borrowers had gained from the preceding inflation would be quickly wiped out, except for those thrifty souls who had prudently taken out fixed rate mortgages. The U.S. government would be forced to cut back spending not by a third, as is currently necessary, but by more than half, financing the remaining deficit offshore in yen, renminbi and Singapore dollars, the currencies of the thrifty and provident Asians. The squeals of the electorate subjected to this usurious brutality would be deafening, but they would be drowned fairly quickly by the roar of job creation, as desperate companies scrambled to sell their cripplingly costly capital assets and reinvest in suddenly cheaper labor.

In the long run, the United States will probably arrive at the place predicted by Reinhart and Rogoff: a long-delayed recovery, with living standards depressed by the costs of eliminating debt. However it will have chosen a bizarre and excessively painful way of getting there.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)