Europe’s Modern Titanomachy: How Europe’s future is being shaped by large battles on seemingly small matters (Part C)

In this three part series (click here for Part A and here for Part B), I have cast a critical gaze upon recent developments which have caused a degree of jubilation in a continent that has not had any ‘good news’, regarding its integrity and future direction, for a while. Part A offered an overview of developments leading to Mr Draghi’s recent intervention, that coincided with moves toward a banking and fiscal union. Part B outlined the views of optimists, whom I called Euro-loyalists courtesy of their tendency to believe that, in the end, Europe’s elites will  “come through”. In this part I explain the reasons why today’s Great Expectations (regarding the ECB’s intervention, banking union, Brussel’s federal moves etc.) are more likely to prive Dickensian than literal.

PART C – The Euro-critics interpretation of OMT as a non-credible mechanism that may seal Europe’s disintegration

The Euro-loyalists’ nightmare

Euro-loyalists, who are currently applauding Mr Draghi’s bold OMT move, fear one thing: that Mr Draghi’s bazooka is not credible. Indeed, to be credible, and thus have a chance of becoming the foundation of a future fiscal union, even a federation of sorts, the OMT bazooka must come equipped with a credible threat: the threat of withdrawing OMT from a member-state that fails to rein in its fiscal deficit.

Mr Draghi, in other words, can threaten to withdraw OMT support but talk is cheap and for a threat to be credible its issuer must convince the world that, when it comes to the crunch (i.e. when his terms and conditions have been violated by the other party), he will be better off ex post doing that which he threatened to do ex ante. [In simpler words, when I threaten my daughter that I shall stop breathing till I die unless she does her homework, she has every reason to ignore me, knowing that, if she does not do her homework, I will be far worse off if I carry out my threat, compared to how things will be for me if I do not carry it out.]

Let’s analyse Mr Draghi’s credibility problem in the context of a simple, though not simplistic, depiction of what we may call the Game of Two Marios (one Mario being Mr Draghi, representing the ECB, the other Mr Monti, the Italian PM; who is standing in here for any of the fiscally-stressed countries that may be applying for OMT assistance). According to the main, Euro-loyalist scenario, Mr Monti has two decisions to make, sequentially. First, he must decide whether Italy needs the ECB’s assistance so much as to apply for an ESM-EFSF program; the prerequisite for Mr Draghi to mobilise OMT on Italy’s behalf. If Mr Monti does not apply, and the markets realize that Italian bonds will not be purchased by the ECB, Italy will be consumed by the ongoing debt-deflationary spiral which caused Mr Draghi to conjure up the OMT program in the first place. Let us now see what happens if Mr Monti does apply for OMT assistance: The best scenario for Italy’s politicians is that the OMT goes ahead, harsh austerity measures are avoided (with only austerity-light being administered by Mr Monti) and, even though the deficit reduction targets are not met, Mr Draghi ‘chickens out’ and continues with his OMT (despite negative reports from the troika). Under the present circumstances, that would be the best outcome for Mr Monti and Italy. On the other hand, if Mr Draghi does cut Italy off the OMT, in reprisal for missed fiscal consolidation targets, this would be an unmitigated catastrophe for Italy, with an exit from the euro as the most likely outcome.

Taking stock, Mr Monti’s preference ordering looks something like this:

Best outcome = Apply for an OMT program, implement mild austerity contrary to the troika’s demands, and wait for Mr Draghi to continue with the OMT despite Italy’s missed deficit targets

2nd best outcome = Apply for OMT, implement harsh austerity in accordance with troika demands, achieve deficit reduction targets against a background of social and economic collapse, observe Mr Draghi continuing to print euros to support Italian state borrowing

3rd best outcome = Not apply at all for an OMT and doing the best he can without ECB assistance

Worst outcome = Apply for OMT only to be cut off it later by Mr Draghi due to failed fiscal targets along the way.

Let us now turn to the other Mario, the one heading the ECB. How does he rank the same four outcomes? We know that his best outcome would be for Mr Monti to apply for an OMT program and meet his fiscal targets. That way, Mr Draghi’s OMT will have proved successful and he will not be put in the difficult position of having to consider cutting Italy off. For similar reasons, Mr Draghi’s second best option would be for Mr Monti not to apply for an OMT – again, sparing Mr Draghi the pain of having to consider cutting Italy off. What is not clear is how Mr Draghi ranks the remaining two outcomes; the ones that would result if Italy applied for a program and failed to meet its targets. What is worse for the ECB and Mr Draghi? That Italy is cut off (on the basis of some, or several, negative troika reports), with all the catastrophic repercussions of such a move? Or that the ECB’s credibility is dented courtesy of the common observation that it does not carry out its clearly issued threats? Let’s, for the moment, keep an open mind on which of the two catastrophies Mr Draghi dreads the most.

The following diagram captures the Game of the Two Marios, showing how Mr Monti’s two decisions interact with Mr Draghi’s conundrum. Mr Monti knows that if he does not apply for an OMT (i.e. follows the left arrow at the beginning), Italy will end up with its 3rd best (or 2nd worst) outcome. Does this mean he should apply? Let’s see. If he does, he will then have to choose between introducing the harshest of austerity programs in order to achieve the troika’s fiscal demands and not doing so, in the hope that Mr Draghi will not dare interrupt the OMT for fear of a wholesale Eurozone collapse. The whole issue hinges on whether, faced with failed fiscal targets, the ECB would pull the plug on Italy (Mr Draghi’s dilemma is located at the bottom right hand side of the tree diagram, at the blacj node-circle).

To recap, a rational Mr Monti would think as follows: “If I do not apply for OMT, my country, and I, will end up with a terrible outcome (our 3rd best or 2nd worst). If I apply, then I have a choice between the harshest of austerities, that will get me my 2nd best outcome (even though the social and economic damage caused will be tremendous), or opt for austerity-light (to minimise austerity’s social costs) hoping that the ECB ranks a discontinued OMT program below an OMT that continues in spire of missed fiscal targets. Put differently, Mr Monti’s Italy will either have to apply for an OMT program or markets must feel that it can do so, if needed, and that, if it does, the ECB will not discontinue it come what may.

The trouble here is that everyone knows that, if Italy does apply, it will only implement the degree of austerity demanded of it in the case where Mr Monti estimates that Mr Draghi ranks the bottom right outcome as number 4 (in his preference ranking), assigning the third rank to a failed and discontinued OMT program for Italy. For if it were common knowledge that, faced with failed fiscal targets, Mr Draghi will not dare to withdraw OMT support for Italy, Mr Monti has good cause to breach his austerity commitments (see below for a proof). Thus Mr Draghi’s credibility with the German Parliament would be shredded and that the Bundesbank’s line would prevail, killing the whole OMT idea off and starting the process of the Eurozone’s dismantling. Game over! 

In summary, the Euro-loyalists’ worst fear is that Mr Draghi has created a game that he cannot win. That the only chance of winning it is if either Mr Monti (or, more generally, the leaders of countries applying for OMT help) has a personal commitment to harsh austerity, or Mr Draghi can convince political leaders in advance that he is prepared to press the Eurozone’s self-destruct button (i.e withdraw OMT support after it has already began) whenever a member-state has failed to meet its program’s fiscal commitments. Neither condition seem likely to hold.

On the one hand, no government can genuinely come to love harsh austerity as an end-in-itself, and to be able to continue imposing it relentlessly in the face of increasing popular discontent. (Just ask Herbert Hoover or, indeed, George Papandreou.) On the other hand, no ECB President can convince politicians that he will prefer to pull the plug on an OMT program, rather than find a rationale to continue with it, if their fiscal targets are continually missed and they relent in their implementation of increasingly harsh austerity.

If I am right in the above, the diagram points to a single outcome: At the beginning of the game, Mr Monti knows that if he and Mr Draghi ever reach the solid black node (or circle) where Mr Draghi will have to choose, the ECB’s President will opt to move along the final rightward arrow; i.e. to continue with the OMT. So, should Mr Monti apply for an OMT? And if so, should he implement ‘properly’ harsh austerity? Being a smart operator, Mr Monti knows that, if he does not apply, Italy ends up with its 3rd best outcome (out of 4). But if he does apply and then adopts austerity-light, proceeding along the ‘insufficient debt reduction’ arrow, then Mr Draghi will continue with the OMT and Italy, and Mr Monti, will get to their first best ‘destination’. Markets will, sooner or later, work this out and will predict that, in the fullness of time, the Bundesbank will win the debate in Germany, thus causing the end of Mr Draghi’s Outright Monetary Transactions. At which point, the Crisis will reach a hideous crescendo.

The Euro-critics’ interpretation of Mr Draghi’s credibility problem

In the Game of the Two Marios above, the lynchpin producing the ECB’s credibility problem in the eyes of Euro-loyalists (though not in my eyes!) is the common knowledge that, once in the clutches of an ESM-EFSF-OMT program, the government of a country like Italy does not have an incentive to do its utmost to reduce its deficit to a level consistent with the troika’s aims and demands. This is a legitimate fear. Alas, it underplays seriously the true extent of the ECB’s conundrum: For even if Mr Monti acted as if a Lutheran priest determined to exact the harshest of austerities upon his brethren, and even if Italians were determined to keep him in power for as long as it takes to reach the troika’s deficit reduction targets, these targets would not be met. There are two reasons for this.

The first is the obvious problem with a country that lacks its own currency, caught up in a debt-deflationary cycle. Think Holland in the early 1930s: determined to stick to the Gold Standard, it struggled (with commendable protestant determination) to escape this cycle through cuts and more cuts; through liquidating asset price bubbles, banks, labour, companies etc. The result was it crashed and burned faster and deeper than any of the other comparable mid-war economy. The OMT’s conditionality constraints, if imposed, guarantee that the Eurozone’s Periphery will continue along its present path toward a 1930s-like Netherlands.

The second reason has to do with the dynamic links between the various member-states. In the Game of Two Marios I have ignored the rest of Europe, concentrating on the interaction between the ECB and one nation state, Italy. The problem, of course, with the Eurozone are the linkages which create a Mexican Wave of insolvencies running throughout the currency union. In a much earlier piece I had constructed a cross-diagram depicting this brutal dynamic. For convenience I paste it below (for its explanation please refer to the original article here or to the Appendix below). 

Mr Draghi’s OMT will do nothing to annul this deconstructive process predicated as it is upon serial austerity drives. Looking at the top right hand side of the diagram, it is now clear that the Eurozone Crisis has climbed up the downward sloping 450 line (as predicted by that analysis) to the extent that the ‘fallen’ member-states are not only fallen because of high interest rates/spreads but because the Crisis has caused (a) massive capital flight and (b) a frenzy of asset liquidations which then feed the capital flight.

Once in this phase, the Crisis could only be ended if the ECB’s interventions were a given come-what-may. Instead,  Mr Draghi, in order to carry with him the majority of the ECB’s Council, had to tie OMT up to an impossible commitment: that fiscal consolidation was a matter of political will and that political will was enough to dissolve the dynamic which the above diagram depicts.


Mr Draghi ingeniously passed his OMT through the ECB Council by claiming that it was not a scheme to fund governments. He could not have said otherwise, without being taken to task for violating the no-bailout clause of Europe’s Central Bank. However, conditionality (i.e. tying up an OMT program for a specific country to its submission to a troika program) was not necessary in this regard. Mr Draghi could have announced his own version of Quantitative Easing, without limiting his purchases to Peripheral bonds, and justify it on purely monetary policy grounds (using a combination of the arguments he used and those of Mr Ben Bernanke of the Fed).

Alas, it became necessary to impose (troika-supervised) fiscal constraints upon his own hand into order to appease potential dissenters, e.g. Mr Asmussen within the ECB and indeed Mrs Merkel without. Thus emerged the blending of OMT with troika-supervised austerity which hinges on the credibility that the ECB will cut off OMT for any country failing to pass a troika test.

Mr Draghi seems to believe, along with Euro-loyalists, that:

(a) it is a matter of political for countries like Itlay will to meet the troika-supervised EU-IMF-ECB conditions, and

(b) his commitment to pull out of OMT if these conditions are not met can be rendered credible.

Me Draghi is, unfortunately, wrong on both counts.

By tying up his credibility on the denial of the underlying dynamic that has brought us this Crisis in the first place, he has created a monster that will inevitably turn around and bite him. Italy and Spain (just like Greece, Portugal and Spain before) will apply for an ESM-EFSF-OMT program only when their situation is so desperate that their commitment to deficit reduction (via harsh austerity) lacks credibility, in turn wrecking the ECB’s own credibility regarding the threat to discontinue an OMT program when deficit reduction falls through.

This sequential credibility loss will mean one of two things: Either the markets will soon see through OMT, and the Crisis will be back before it even gets a chance to prove its worth. Or, once OMT have began (say, with Spain or Italy), either a significant country will be thrown to the dogs and out of the Eurozone’s pen (i.e. its OMT will be discontinued) or the German government will lean heavily upon the ECB to put an end to, effectively, all OMT programs. Either way, the Eurozone will not be able to survive these strains and, naturally, the Euro-loyalists’ dream of gradual federation will wither.


In this three part post I asked a simple question: Have recent developments given us grounds for hoping that Europe is, finally, getting its act together. A string of ‘goods news’ stories have, indeed, blown fair winds into the sails of optimists, Euro-loyalists I choose to call them, who claim that Europe is now showing signs of moving in a right direction with a speed that, while not earthshattering, will outpace the Crisis. Noises about a banking union from Brussels, the German Constitutional Court’s decision not to block the ESM, Mr Baroso’s bold plan for a Federal Europe and, above all else, Mr Draghi’s poignant Outright Monetary Transactions (OMT), these are the developments that give a semblance of a Europe regaining its poise and embarking upon a path to ‘more Europe’.

There is little doubt that recent moves would be unthinkable only very recently. A German Chancellor arguing in favour of central supervision of banks, a german member of the ECB’s Executive Board supporting unspecified purchases of Italian and Spanish bonds, a European Commission position paper outlining federation in the next few years; all these ought to be earthshattering developments that warm the hearts of those of us who think that the disintegration of the European Union, with all its many faults, would be a major blow to future generations worldwide.

And yet, as the patient reader of this long article will have surmised, I fear that these momentous developments leave us precious little room for optimism. The main reason is that, behind the discussions on the minutiae of banking unions and OMTs, a Titanomachy rages; a clash of Titans that is muffled but perfectly capable of destruction of an order that is unimaginable. We can only sense these battles from the way that ‘small matters’ (e.g. whether the ECB will be supervising all the banks or just the ‘systemically’ important ones) puzzlingly manage to bring our leaders to unexpected dead ends. For underneath the surface, on which we notice these seemingly minor disagreements, there are Titans (e.g. Deutsche Bank) who are lashing out mercilessly against each other and against the revelation of their interests and situation (e.g. their insolvency, which German banks want to keep out of sight by keeping their various tentacles in the shadow banking world out of the ECB’s reach and oversight). Like the mythological Titanomachy so here there are various clashing Titans and a variety of alliances of convenience between them. Europe’s institutions may well prove too flimsy to contain their struggles, especially so as the Great Recession (which has become a Great Depression in parts of the Periphery) are robbing them of the oxygen of popular support and democratic legitimacy. Tragically, even the best meaning politicians and apparatchiks (e.g. the two Marios), are being forced by the underlying Titanomachy into games that they cannot win, with Europe and the world at large ending up as the grand losers. 

Appendix – The cross diagram explained

For the readers’ convenience I copy below the explanation of the four part cross diagram which featured above:

The purpose of any cross diagram is to combine four diagrams in one in a manner that makes it easier on the eye to see the interconnections between its parts. To read this particular cross diagram, please note that all axes are positive. For instance, in the bottom right part of the diagram, a downward movement signifies an increasing α(F). Similarly, in the top left part, a leftward movement signifies an increase in s, the eurozone’s average spreads. Having established these simple conventions, it is time to define our four axes.

Top right diagram: The horizontal axis counts the number of solvent member-states. At the outset, i.e. just before the Crisis set in, all N member-states fell in that category. After the first member-state ‘fell’ (i.e. Greece), the number of solvent member states diminished to N-1 (see the horizontal axis) whereas the number of ‘fallen’ states F (see the vertical axis) went up to one. With every member-state that ‘falls’ we climb one notch up the straight line.

Bottom right diagram: Here we find the relationship between the EFSF’s toxic ratio α(F) and the number of ‘fallen’ member-states F. With every new member-state that ‘falls’, we move to the left of the horizontal axis and α(F) rises along the thick red curve. This simply signifies that as more countries fall prey to the Crisis, and require official bail outs from the rest, the remaining solvent countries are facing a rising α(F): Put differently, the ratio of the debts that the solvent must now guarantee over their aggregate GDP increases even if the eurozone’s aggregate debt and aggregate GDP remain the same (indeed, even if the eurozone’s aggregate debt-to-GDP ratio is constant or falling!).

Bottom left diagram: The new axis added here (that runs from the cross diagram’s centre leftward) is the average of the interest rate spreads (i.e. the average difference of member-state interest rates from the lowest interest rate in the eurozone, i.e. Germany’s) facing eurozone’s still solvent states. What happens when α(F) rises in response to the ‘fall’ of a member state that has recently made the awful transition from being an EFSF donor to an EFSF recipient? The simple answer is: Interest rate spreads rise throughout the eurozone. This simple truth is captured here by the blue curve s(α): E.g. When Ireland ‘fell’, α rose and the markets got more jittery about the capacity of Portugal, the new marginal member-state, to shoulder not only its own debt burden but also the added burden of its contribution to the Irish bail out. Markets, in these circumstances, react (naturally) by pushing up the spreads of still solvent nations with a high-ish debt-to-GDP ratio and relatively sluggish growth. Thus, the positive relationship between a(F) and s in this part of our cross diagram.

Top left diagram: Each member-state has a limit beyond which it cannot refinance its existing debt when the interest rates it is called upon to pay reaches a certain threshold level. This is what happened to Greece in May 2010, to Ireland a few months later, to Portugal in the Spring of 2011 and, soon, to Spain and Italy (which will run out of money in September 2011 and February 2012 respectively). In this, final, part of the diagram, the assumption is that pre-crisis average spreads equalled s0. The other values of s, si, depict the level of average spreads facing still solvent member-state i above which it too ‘falls’ and joins the EFSF list of recipient states.

Let us now use this diagram to answer the original questions: Why Italy and Spain? And why is the actual size of the EFSF immaterial? Let us begin our account at the two points that the diagram marks as starting points: In the top right diagram it is point N on the horizontal axis (corresponding to the initial condition when no member-states had yet ‘fallen’) while in the top left diagram it is the average interest rate eurozone spreads level s0 (on the horizontal axis). For reasons that I shall not discuss here, at some point average spreads began to rise sometime toward the end of 2009. When they reached level s1, this triggered the Greek crisis and, after many trials and tribulations, the Greek bail out of May 2010. Once Greece had fallen, the average contribution of each of the remaining member-states, which hitherto equalled zero, rose to level α1. The result was a further increase in average spreads until s reached s2, thus causing Ireland to ‘fall’. [The reader ought to trace the continuous arrow that begins at s0 (see top left diagram), shifts leftwards to s1, then jumps up until F rises from 1 to 2 (i.e. Ireland joins Greece – see top right diagram), then proceeds to the bottom right diagram pushing α to α2 before migrating again to the bottom right diagram where it pushes average spreads to s3, a level that throws Portugal off the cliff etc. etc.

There are two points to note here, before moving to my concluding remarks:

First, the best we can say about our European leaders is that maybe they had hoped that the gradient of curve s(α) would prove less steep and, thus, might have prevented the cobweb-like explosion from occurring. If so, they ought to have known better. For the slope of this curve is not cast in stone but is predicated upon the psychology of the markets. In view of the gross uncertainty at a global level, to bury a toxic ratio, like α(F), in the foundations of your anti-Crisis apparatus (the EFSF) is to ask for trouble.

Secondly, Germany and the rest of the surplus countries were hoping that the loan guarantees that they were offering to the EFSF would never need to turn into actual cash transactions. This would, indeed, be so if the EFSF had a coherent structure: its very institution would have averted speculative games by market traders and German taxpayers would never have had to cough up the euros associated with the loan guarantees to the EFSF. But, with the toxic α(F) inside the EFSF’s foundations, markets recognise the shape of the cross diagram above. And nothing pleases them more than an opportunity to bet against an official’s incredible threat, promise or prediction. If only for this reason, it was insanity personified to imagine that the α(F) curve might turn out slight enough to help contain the contagion. In short, our leaders ought to have known better.

39 thoughts on “Europe’s Modern Titanomachy: How Europe’s future is being shaped by large battles on seemingly small matters (Part C)

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  10. USA has a CA deficit and a public debt that is growing fast.Still no problem.Its a matter of having currency sovereignty not a matter of ca balances.

    Crossover, don’t make such naive remarks. It is dangerous
    It is still CA account . Selling printed paper againt goods.
    The Germans still have the incineration oven. It will be cleaner and more effective.
    US has the H bombs, if you destry their toy, they will get angry

    • “Selling printed paper againt goods.” True.If the chinese didnt want this printed paper then they would find a different buyer.Simple.Its not like they dont want it and the US is forcefeeding them.

    • Moreover,the CA deficit of US is due to China keeping the exchange rate fixed and not letting the Yuan appreciate against the dollar.Do you see any similarities with the Eurozone ?

  11. What im about to post is not exactly relative to the topic,nevertheless i think it is very interesting and worth reading in my opinion.

    This was written by Michael Johns. I saw him on C-Span, contacted him, and have been in touch ever since. Michael is a conservative, and one of the Tea Party founders. As you can see below, however, he too recognized the very wrong and counter agenda turn taken by the Republicans (and then the Tea Party) when they embraced deficit reduction and the balanced budget amendment for its own sake. He wrote this most prescient article in 1996 if I recall correctly, which was published in the Washington Post:

    A Balanced Budget Is Not the Answer

    by Michael Johns

    In its political toughness with the Clinton White House in recent months, the Republican leadership in Congress has elevated balanced-budget proposals to the top of America’s political agenda. Although at least nominal political differences exist over the means to arrive at this objective, the embrace of a seven-year balanced-budget goal by both Republican congressional leaders and President Clinton represents the most significant shift in the economic thinking of the political elite in perhaps two decades. The concept of balanced budgets has long existed as a weapon in mainstream political rhetoric, but only since the 1994 elections has this rhetoric run the significant possibility of becoming political reality.

    Yet before such a goal is uniformly embraced and enacted as policy, Congress and Clinton should pause to reflect on whether such an objective deserves its place at the pinnacle of our economic objectives. Upon such reflection, there is good reason to believe that it does not.

    There is, for instance, no historical data that would demonstrate that a balanced budget enhances gross domestic product (GDP) or any other indicator of economic productivity. Balanced budget advocates have long contended that the absence of a balanced budget opens the door to a “crowding-out effect? on interest rates, whereby government borrowing actually closes out private borrowing, thus raising interest rates on private credit and slowing the economy. Contrary to this, however, some of the most profound drops in interest rates and expansions in economic growth have occurred at moments when the deficit has been on the rise (witness, for instance, the interest-rate drop and economic growth that largely characterized the eight-year Reagan administration period).

    Nor is there any particular evidence demonstrating that our current budget deficit is necessarily at the root of any particular economic problem that a balanced budget would correct. True, the balanced budget is a convenient political means for cutting the substantial waste and even fraud that exists in federal expenditures, but there is no reason to believe that this could not be accomplished short of wedding our nation’s policy leaders to a squarely balanced budget in every fiscal year.



    Perhaps most convincingly, America does have some previous experience with balanced-budget efforts, and it is cause not for celebration but considerable alarm. Without exception, on six consecutive occasions from 1817 until 1930 when government cut spending considerably without simultaneously seeking to stimulate the economy with equally deep tax cuts or other fiscal stimuli, depressions arose. The correlation is a shocking 100 percent. Balanced-budget efforts in America have always preceded national depressions.

    So why are we doing this? It is reasonably apparent, on close examination, that the balanced-budget debate, rather than seeking the advancement of any specific macroeconomic goal is more a convenient means by advocates for accomplishing other political objectives that otherwise might be less sellable. On one hand, for instance, many congressional Republicans see the balanced budget as a political vehicle for enacting sweeping cuts in federal spending that, without the political cover of a balanced budget, likely would be significantly more difficult to sell to the American people.

    On the other hand, many Democrats, including President Clinton, appear to see the balanced budget as a far-off and thus somewhat meaningless objective; even if Clinton were reelected, the current proposals would not force him to balance even one budget in a second term. Perhaps because of this, he has seen little imperative in resisting the plan. In January, one senior Clinton aide conceded that the administration’s endorsement of a balanced budget was just “a public relations game.”

    Also not considered by many Republicans is the fact that some Democrats may even see the balanced budget as a means for providing political cover for eventually increasing the tax burden on the American people, even though such fiscal steps have been universally discredited over the past two decades. Nonetheless, if maintaining balance in the federal budget is the nation’s top economic priority, the balanced budget could likely be used over time to justify enhancing federal revenue through larger tax demands on both private citizens and businesses. Short of this, congressional Democrats will almost certainly use the balanced-budget restrictions as justification for resisting any Republican-sponsored tax cuts.

    For Republicans and fiscal conservatives, this raises the question of whether the political cover for spending cuts that accompanies a balanced budget is worth the risk of providing Democrats and fiscal liberals with the same level of future political cover for raising taxes. The answer is that it most probably is not.

    Of course, the political sentiments that have advanced the balanced budget cannot be thrown aside. Congressional conservatives are largely correct in their bid to eradicate wasteful government spending and to transfer from the public sector to the private sector those responsibilities that would more appropriately be handled outside of government. Yet cutting wasteful spending does not necessarily require embracing a balanced budget. Under a fiscally conservative president, such steps could be taken through enacting a line- item veto. Short of this, Congress could use the widespread support for smaller government to cut spending and taxes simultaneously, without operating on the premise that a precise budget balance is necessarily the most pressing priority.

    Perhaps the most compelling reason to resist a balanced budget, however, is the fact that, politics aside, there simply is no reason to believe that a balanced budget will provide any economic stimulus to the economy, and there are at least a few reasons to suspect that it may do great harm. In addition to the absence of any historical data in the United States or elsewhere in the world that demonstrate any connection between balanced budgets and sustained economic growth, there is no reason to believe that America’s budget deficit is necessarily at the root of any current macroeconomic dilemmas. A comparison of budget deficits as a percentage of GDPs reveals that Americas budget deficit is reasonable, even low, compared with that of other industrial nations.


    Additionally, a close look at the relationship between deficits and economic growth in countries around the world reveals that deficit-reduction measures are often followed by downturns in economic growth. Conversely, increases in deficits often accompany economic upturns. In Great Britain, for instance, a reduction in debt from 1989 to 1991 from roughly 44 percent of GDP to 34 percent also witnessed a reduction in GDP during this period from O percent to negative 4 percent. Since 1991, Britain’s public debt has increased to roughly 52 percent of GDP, and economic growth also has risen dramatically to 5 percent GDP in 1995. What such examples demonstrate is that, contrary to the conventional wisdom of balanced budget advocates, there simply is no reason to believe that a balanced budget will enhance economic growth or prosperity, and there is, in fact, good reason to believe that it may do harm.

    All of this raises the question of whether congressional Republicans, in their emphatic embrace of balanced budgets, may now be playing the wrong political card with the Clinton White House. Instead of elevating the balanced budget to the top of the Republican agenda, why not more aggressively challenge Clinton to cut or eliminate the federal tax on capital gains or reduce the marginal rates of federal taxes, two steps that almost unquestionably would spur economic growth?

    Of course, congressional Republicans, particularly many freshmen, support such goals enthusiastically. But perhaps surprisingly, the Republican leadership in Congress has not chosen any of these as the primary issue of confrontation with President Clinton; instead they have chosen the balanced budget, even though the president has at least verbally endorsed such an objective.

    Responding to this criticism from House Republican freshmen. House Speaker Newt Gingrich has made it clear that the objective of a balanced budget surpasses any other progrowth initiatives. “They have two highly competitive desires: to balance the budget and a tax cut,” Gingrich was quoted as saying about Republican freshmen in January. “At some point, you’ve got to say, ‘O.K., which has precedence?’ And I think in the end, balancing the budget does.”

    But just as relevant as the politics that drives the balanced-budget crusade is the fact that, while politically and rhetorically advantageous at the moment, the case for elevating a balanced budget to the top of our economic priorities is also based on a significant oversight or distortion of several critical historical economic facts.

    The 100 percent correlation between previous balanced-budget efforts and national depressions, for starters, needs to be explored further by those who would again lead America down this path. It is likely not coincidental, either, that another, opposite correlation also exists. Periods of significant and sustained economic growth in this country have occurred nearly always in times when the deficit was on the rise.


    Why might this be the case? Warren Mosler, the director of economic analysis at the investment firm Adams, Viner, and Mosler, offers up a possible answer in his book Soft Currency Economics. According to Mosler, American policymakers have not yet adjusted their thinking about monetary and fiscal policy to a post-gold-standard era.

    In this new era, the common notion that government requires private money to pursue its spending is no longer true. Under the current fiat currency system it is the economy that needs government money to pay taxes. So under this scenario, if the government taxed American citizens and businesses $1.3 trillion and then, in the extreme case, spent none of it, a depression would inevitably follow in the frantic attempt to liquidate assets.

    None of this, of course, is necessarily an endorsement of deficit spending. But Congress and the White House should ponder at what point the benefits of spending cuts exceed the cost. There is good reason to believe that spending cuts can serve a useful purpose in controlling inflation. But with inflation under control, as it is currently, there is equally compelling evidence that further spending cuts without matching tax cuts will prove recessionary and ultimately depressionary in their macroeconomic impact.

    “But we need to balance the budget for our children and grandchildren,” comes the reply from the hard-core balanced-budget advocates on the left and right of the political spectrum. Well actually, there is no significant reason to believe that future generations will necessarily be unfairly burdened with a running deficit. The primary obligation of government is to provide future generations with a growing economic climate and sufficient economic infrastructure to compete effectively in an increasingly competitive global market. Surely if a balanced budget proves depressionary, government is not serving this larger purpose.

    Nor is there any reason to believe, as some balanced-budget advocates contend, that future generations will be forced to pay back any lingering deficit. For one thing, in real terms, this would be virtually impossible; the GDP of future generations -all the goods and services offered up by that generation-belong to that generation and cannot possibly be passed backward through time to pay past debts. With a gold-standard, there was a price to pay; gold could be removed from the national supply to cover deficits. But under America’s current fiat currency system, a deficit really is nothing more than accounting.


    How about a deficit’s impact on savings? Some balanced-budget advocates contend that deficits eat into savings, thereby endangering the economic health of the nation. This, for instance, is largely the belief of the current Federal Reserve Board, including its chairman, Alan Greenspan. Yet this thinking overlooks the obvious. Real savings is more properly measured by real invest meet. If the effect of spending cuts without substantial accompanying tax cuts is to depress such investment, a balanced budget actually would impact savings, in a negative manner.

    Beyond the economic ramifications, the embrace or rejection of these seldom-mentioned facts by American leaders will also likely have significant political ramifications. A political leader whose message is one of growth, expansion, and opportunity, for instance, will likely have a great chance at winning the hearts and minds of the American people, much like Ronald Reagan did with his powerful promises of economic expansion in 1980. Distressingly for Clinton’s reelection prospects, however, it appears that the White House is largely rejecting such a message.

    This past January, for instance, Clinton’s chief economic adviser, Joseph Stiglitz, echoing administration sentiments, warned that the country’s current economic growth average of 2.5 percent is about the best that Washington can expect. He rejected the findings of Jack Kemp’s Commission on Economic Growth and Tax Reform that predicted that flat tax reform would likely double the country’s economic growth. Clinton’s message, as such, appears to be to convince the American people that there are inherent limits to their dreams and possibilitiesthat we ought to adjust ourselves to a less-than-perfect economic climate.

    To Clinton’s political benefit, however, it does not appear that congressional Republicans have, at least in the minds of many Americans, clearly defined a progrowth economic agenda for the country either. Of course, many Republicans have championed such policies, but at least in part because of their ongoing obsession with a balanced budget that is based on a message of fear and frugality, this message has not resonated to the extent many Republicans may have hoped.

    Yet there exists within some political (mostly Republican) circles great hopes that this message may still win the day. Echoing these sentiments, New York investment banker Felix Rohatyn, a leading candidate to fill a prominent Federal Reserve vacancy, observed in a New York Times op-ed piece last November that “the vast majority of the business community believes [the current economic growth rate] to be far short of our economy’s real capacity for noninflationary growth, as well as being inadequate to meet the nation’s private and public investment needs.”

    Spurring growth and rejecting the ill-placed fears of some of our nation’s most hardened balanced-budget advocates represents perhaps the best hope for America’s economic advancement. But getting there will require a new look at some economic facts that, while currently not the focus of our political culture, require pressing attention.

    Michael Johns served in the Bush administration as a speechwriter at the White House and U.S. Department of Commerce and previously as a policy aide to former New Jersey Gov. Thomas Kean. He is now a public-policy analyst and consultant based in Arlington, Virginia.


  12. Pingback: Has Mr Draghi created a game that he cannot win? Probably and it's not just about…

  13. Mr Draghi implied that ΟΜΤ can purchase and 10-y bonds with a residual maturity of less than 3 years. How many 10-y bonds ending in less than 3 years in Spain -Italy, specifically?
    Conditionality exist in a way to deter the IMF-Troika involvement so governments engouraged to mild austerity with EU probably only supervision.
    It’s complicated however, banks do have to make asset write-offs, but not like Greece.

  14. The flaw in the above diagram is the lack of consequences should Italy exit the Eurozone. From what appears in the Game of Two Mario’s Italy would be indifferent between remaining or exiting the Eurozone, which is a very large simplification. Also, the fact that after a recessionary period, growth would reestablish in Italy (or any other nation for that matter) has not been selected as an outcome. The rest of my comments are here:

  15. Pingback: Yanis Varoufakis: The Game of the Two Marios « naked capitalism

  16. Yanis,

    you seem to forget that the problem is not a question of debt, but more a question of current accounts. The issue of the current accounts is again an unsolvable problem since the total (Euroland, global or whatever) balance has to be zero But let’s forget it for the moment. if Italy, Spain Greece had a huge positive current account balances they could sustain the highest public debt and live well (see Japan). Maybe the toital debt would be dwindling.
    Hence fist step is to re-stablish competitivity. But that brings to the thieves and robbers hidden inside the public admistration sustained by the politicians in charge A country like for instance Italy where taxes are eating more than 50% of the GNP without giving back a proportional return to the the society to justify such a level of taxation cannot but end up in bankrupcy in a gold system like the Euro is.
    Do you read the Italian newspaper where everyday they are news of millions and million of Euro wasted like peanuts?

    The second Mario has so far only raised taxes. Just lip service to the action to cut the huge area of waste. It is politically impossible now.

    If Mr. Monti appeals to the IMF, that might be the only way to get the power to eliminate the thieves eating the country.

    Better solution would be if the Germans recreate the SS. Send them around in the piggy countries to kill the thieves. That would be faster and simpler and solve all the problems for a while. The robbers will come back, but after some time

    • “. if Italy, Spain Greece had a huge positive current account balances they could sustain the highest public debt and live well (see Japan).”
      USA has a CA deficit and a public debt that is growing fast.Still no problem.Its a matter of having currency sovereignty not a matter of ca balances.

      Furthermore,flee floating exchange rates tend to put opposite pressure to the CA trend,so large trade imbalances tend to not happen.

      “If Mr. Monti appeals to the IMF, that might be the only way to get the power to eliminate the thieves eating the country.”

      Whats the difference if you simply change the thieves that eat up your country?

    • Dear Crossover
      The US model of infinite debt won’t work forever. It has so far but will break down at some point. Not an option / a good model for e.g. Italy.
      Plus, as you say, it matters if a country has its own currency. It helps if that is the world reserve currency (e.g. Poland could not pull that off, the Zloty would devalue and foreigners would not be happy with low interest rate levels. It is really a US-specific thing – and they are in the process of gently losing it).

      Regarding appealing to the IMF making it easier to deal with the thieves: I think that point is not to be dismissed. If you have pressure from outside which forces you to take certain steps domestically, this can be very helpful. It would give Mr. Monti the chance to point to the IMF and say: “They require us to do XYZ otherwise they will cut us off the money supply” – and suddenly what may have taken months of discussions would eventually have gone nowhere may be implemented very swiftly. Makes it easier to point at the IMF, evil Merkel or whatever and then say, “sorry, we unfortunately have to do this” than to implement unpleasant reforms when there still is a way to somehow delay the inevitable.

    • ” It is really a US-specific thing – and they are in the process of gently losing it).” It is not.Unless you can find ONE country that has ever defaulted in debt denominated in its own domestic free floating currency.(s.n: Greece’s own debt was frequently above 100% during the 90′s pre-euro….there was never a danger of bankruptcy). About IMF.I could definitely agree with what you are saying,if i could agree with the policies the IMF is proposing in the 1st place.But having seen the destruction it has caused wherever it stepped on i cant really make the distinction between the IMF and the rest of the thieves.

    • Dear Crossover
      I don’t mean that the US will necessarily default. But their model of infinite debt for very low interest won’t work forever because most likely, foreigners will one day ask for higher interest rates as a compensation for the risk of getting back the principal – but it being worth much less because the US had to inflate a part of the debt away.
      The kind of debt increase they’ve had over the last few years in my eyes can’t go on. Or it will – but then they will have to pay higher interest. So they will then face the kind of questions the ECB may be thinking about: Either inflate the debt away or impose austerity.
      I’d say the US would choose inflation – and the creditors probably agreeing will, once they see the debt level is becoming unsustainable (which may be the case in a couple of years from now) ask for higher interest rates – which will make the US model collapse.

    • “I don’t mean that the US will necessarily default. But their model of infinite debt for very low interest won’t work forever because most likely, foreigners will one day ask for higher interest rates as a compensation for the risk of getting back the principal – but it being worth much less because the US had to inflate a part of the debt away.” This theory has already 2 flaws. 1)Government Bonds issued in domestic sovereign currency are risk free.So there are no worries about getting back the principal.Any yield changes reflect inflationary expectations and nothing else. 2)There is no correlation between increased debt and inflation.Do you have any data? Regarding (1), the same story has been going during the 2 QEs but obviously never materilized. Here’s a funny fact: Dollar Index on 9/19/2011: 77.14 Gold price on 9/19/2011: $1803 per ounce Dollars “printed” in past year according to US Treasury: $65 TRILLION Dollar Index today: 79.05 Gold price today: $1770 per ounce Dollar is up. Gold is down.

    • Dear Crossover
      We agree on that for holders of US bonds, they probably don’t need to worry about getting their principal back. But, certainly if they are foreigners, what matters when assessing if the yield offered is adequate is not only US inflation. As such, inflation in the US is relatively irrelevant for e.g. Chinese, Japanese or German investors. What matters is what the amount of USD will be worth in their own currency once the bond is due. Have a look at the ratio USD/EUR ten years ago and now: the USD lost a lot of value (in spire of the Eurozone being in major trouble).
      So already, the return (interest plus change in USD value) has not been brilliant. This will have an effect on the willingness of foreign investors to lend to the US for low interest: long term, it will be a lot more difficult. At the moment that’s not yet visible because China does not want the USD to devalue quickly and the Eurozone is in a mess with their periphery. But it will happen.

    • “So already, the return (interest plus change in USD value) has not been brilliant. This will have an effect on the willingness of foreign investors to lend to the US for low interest: long term, it will be a lot more difficult. At the moment that’s not yet visible because China does not want the USD to devalue quickly and the Eurozone is in a mess with their periphery. But it will happen.”

      Indeed,the dollar has devalued relative to the euro.But what effect did this have on the US bonds?None.And you can have a look for yourself on that.
      But apart from that.The markets dont dictate the bond rates.The FED does.Just like any other CB can do the same for their respective gvt bonds….except for Eurozone that is.
      China is already manipulating the yuan in order to keep the exchange rate fixed thus the growing US trade deficit (btw does the fixed rate and the trade deficit remind you of a similar story maybe?), so i dont see why would it care.It woud simply keep doing what its doing.

      Btw why didnt Japan go bankrupt?Why didnt the bond yields increase?Why doesnt it have any inflation?

    • Dear Crossover
      If solely the FED dictates the interest rates for bonds, then that would be great news: in that case, the US could significantly increase it’s debt-taking, way beyond a level where the creditors may still realistically hope for the debt/GDP ratio to stabilise around, say, 110% and then gently decline.
      No longer necessary to aim for that in your scenario.
      And foreign creditors would be willing to lend the US government huge amount of money, receive very little interest (cause the FED says so) and get back the principal – but it being worth a lot less because the USD keeps losing value in this scenario??
      I don’t think this will work.
      Japan is a different story: so far, Japan has been a creditor to the world. They are hugely in debt – but the overwhelming holders of it sit in Japan. As soon as Japan gets dependent on foreign money inflow (may happen mid-to long term) they will have to pay much higher interest rates. Which they cannot afford – so they have to avoid or at least delay it. US situation is very different.

    • The CB determines the Federal Funds Rate on a daily basis thus it can determine short term rates (there is almost 100% correlation between fed funds rate and short term gvt securities rate).How does it determine the Federal Funds Rate? By buying and selling securities ie by adding or draining the appropriate amount of reserves in order to adjust the interbank market rate at the desired level.
      The transmission mechanism of the CB’s monetary policy is conducted through government securities.If the securities rates are not following the CBs interest rate policy then the CB is unable to determine the interest rate in the economy.

      Furthermore, there are certain banks that are called “Primary Dealers” and by law are oblidged to generate at least 100% demand for all the gvt bond issues.The issues can never fail.

      Here’s a few more details:

      -The Federal Reserve is a monopolist. The US government, as monopoly issuer of its own currency, has given the Fed monopoly power in the market for base money. The Fed exercises this monopoly power by targeting the overnight rate for money, the fed funds rate.

      -Any monopolist can only control either price or quantity, not both. And the Fed wants to target rates i.e. price. It can’t do that unless it supplies banks with the reserves they desire to make loans at that rate. That means that they must be committed to supplying as many reserves as banks want/need in accordance with the lending that they do subject to their capital constraints. Failure to supply the reserves means failure to hit the Fed funds rate target.

      -Markets know, therefore, that the Fed, as a monopolist, will always be able to hit its Fed funds target now and in the future. Therefore, future overnight rates reflect only future Fed Funds target rates as set by the Federal Reserve. This means that future expected overnight rates reflect only market-determined median expectations of future Fed Funds target rates as set by the Federal Reserve (plus a risk premium).

      -Long-term interest rates are a series of future short-term rates.

      For further explanations this article would help:

    • Btw 2/3 of US debt is held within the US.China might be the biggest Foreign US debt holder….but it isnt the biggest debt holder in general.
      Furthermore the only reason they are buying US bonds is because,having a current acount surplus vis-a-vis US means being a net saver on this country’s currency.But holding money receiving no interest is far less profitable than holding interest bearing assets ie US gvt bonds.

    • Dear Crossover
      Thanks – lots of links & explanations!
      Some of the graphs are very interesting. But I am not sure they necessarily falsify what I wrote regarding foreign investors reluctance (as I see it) to buy US bonds for very low interest rates in a scenario where the value of the USD is decreasing versus the value of the currencies in use at the investor’s countries.
      The foreign investor would be better off to save the money under their mattress instead of buying USD.

    • Well Martin,

      Any investor is free to choose where he wants to invest.With that being said lets see some facts so as to conclude wether it would be a problem or not for the US if foreigners didnt want to buy bonds for whatever reason.

      In most countries there are some credit institutions that are called Primary Dealers.They are mostly banks and they are oblidged by law to participate in gvt bond autctions in the primary market and also be involved in “market-making” for secondary market transactions.No matter what the rest of the bidders do,the primary dealers must create demand for the bonds.

      Here is what the US Treasury says: “the Treasury believes that the government securities market, and hence the Treasury, have benefitted from the primary dealer system. The FRBNY has required that the primary dealers make markets in all maturity sectors of Treasury securities, and that each primary dealer’s share of customer trading volume must equal at least one percent of total secondary market volume. The FRBNY also expects primary dealers to demonstrate their continued commitment to the market for Treasury securities by bidding meaningfully in all Treasury auctions. If a dealer fails to bid meaningfully in an auction, the FRBNY typically contacts that dealer to remind it of its so-called “underwriting” responsibilities.

      The Treasury believes that the existence of a group of dealers with a commitment to the government securities market has been of great benefit to the Treasury. The dealers’ underwriting responsibilities have served to “backstop” Treasury auctions, considerably reducing the risk of insufficient auction cover.” (source:

      Heres what an ordinary bond auction result looks like:

      The primary dealers could have covered the entire auction.

      Now you may think its not fair,its cheatting and that the US gvt wouldnt be able to spend if it wouldnt force the primary dealers to participate in bond issuances the way they do.The truth is,the US govt (such as any other monetarily sovereign gvt that issues a free floating currency) does not need bonds or taxes to spend.In fact,bond issuance only helps the CB maintain its monetary policy and be able to hit its federal funds rate target.I know you may think this sounds absurd but if you want to argue over this matter then please have a look at this research paper first because i would need to write a bunch of lines here which probably dont interest anyone here:”Can Taxes and Bonds Finance Government Spending?”

      As for your comment about the charts, well the 1st graph shows how the bond rates follow monetary policy all the time no matter the worries of the gvt suddenly going broke or whatever.

      2nd graph simply shows whether the markets see any risk on the growing debt or not…the answer is obvious imo.

      By the way, according to the Basel Accord, there is a capital to risk-weighed assets ratio that Banks must hit,in order to be able to make loans.Government bonds are considered risk free thus they dont cause this ratio to deteriorate.They must be considered risk free for a reason,dont you think?Imo this highlights the utter stupidity that reigns in the eurozone.

  17. Mr. Varoufakis, I think you are wrong in many ways.

    First of all, the best outcome for Mr. Monti, the ECB and everyone else would be a reduction of interest rates for Italian government bonds to a level which doesn’t require an official bail out. Mario Draghi created the OMT program to show that the ECB will act as a lender of last resort if that becomes necessary in order to impress the markets and reduce interest rate spreads. Mr. Monti has never intended to use this instrument, avoiding such a program is the very purpose of his government, using this instrument would equal failure in his eyes and in the opinion of most Italians. And he will never have to use it if he continues with his reforms and if Italy gets a government in which Berlusconi has no say next year. Italy’s fundamental data are not that bad, Italy simply needs some more time during which interest rates are lower than they were before. So your 3rd best outcome is in fact the very best one, your worst scenario isn’t possible, your “best outcome” is entirely unrealistic since Italy’s deficit is relatively low and not even the Troika would demand “harsh austerity”, your “best outcome” is only the second best and the most realistic one if Italy applies for a bail out. The same applies to Spain, but it is rather unrealistic that Spain can avoid another program.

    The OMT cannot be killed by the Bundesbank but by the Federal Constitutional Court of Germany. It is very likely that the court will declare state financing via the money press illegal once again but leave a final decision to the European Court of Justice to decide whether the OMT equals monetary or fiscal politics. The entire procedure will take enough time for Italy to improve her situation.

    Second, you are wrong about the the motives of the big banks. In fact, the biggest banks are in favour of a banking union, regional small banks are against it. For example, Deutsche Bank supports the idea of a Banking Union for all 6000 banks in Europe, but neither small regional savings banks nor the ECB herself support that idea, at least not in the short and medium term. There are many reasons for that, for example conflicts of interest between the different banks as well as practical reasons. Maybe you are not well informed about the “banks’ game”.

    Yours sincerely, a reader

  18. This is the most coherent explanation of the situation I have seen. Thank you.

    Also, I am looking forward very much to reading what you have to say as the situation unfolds.


  19. “…Quantitative Easing…”

    which you seem to prefer, if I decoded your wording correctly, serves mainly the wealthy. Which is not at all a new insight. A lot of non-pundits expressed it since long, whilst the professional economists argued quite the contrary.

    See also here:

    Again this piece suffers from your unprofessional focus on and against Germany. For instance, France is fighting much stronger than Germany against a unified supervision of the banking industry. A fact that is apparently blocked by your filter.

    Ah, and of course, France and all the other ClubMed members are on the other hand side lobbying for a unified deposit guarantee fond – because they would profit, Germany and a few others would lose.

    You know how I, and probably most of the German public sees this? The 4 elements the undemocratic eurocrat centralists are dreaming about are

    - common deposit guarantee fund
    - single authority to liquidate zombie banks
    - common rulebook for banks
    - Integrated enforcement of the rulebook and overall supervision of banks

    Forget the pooling of the deposit guarantees, especially for already existing liabilities. Why should the main street savers in Germany want to get on the hook for the toxic waste Spanish banks have themselves loaded up with? The rest is fine from my point of view.

    • I do not favour QE (for if I did it would be in our Modest Proposal). My point is that it would work better (though not well) than OMT.

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