On The Debt Ceiling & Drowning the Government in the Bathtub

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The mainstream coverage of the debt ceiling standoff and the prospect of government shutdown and how that thing is seen by the people who might precipitate it is predicated upon a fundamental misunderstanding. To the Tea Partiers and Grover Norquist-Ted Cruz-Rand Paul wing of the Republican Party, a government shutdown is seen less as a potential disaster in which markets and society are sent into turmoil, and more as a potential wonderland of enforced austerity where with the government handcuffed, the creative forces of the free market are finally unleashed.

The libertarian financial analyst Mish Shedlock exemplifies these sentiments:

Looking for a reason to support a government shutdown? If so, please consider Obama Stripped to Skeleton Staff in a Government Shutdown.

Mish points to the austerity measures the government would be put under:

 A U.S. government shutdown means President Barack Obama will have fewer people to cook meals, do the laundry, clean the floors or change the light bulbs, according to a White House contingency plan.

About three-fourths of president’s 1,701-person staff would be sent home. The national security team would be cut back, fewer economists would be tracking the economy and there wouldn’t be as many budget officials to track spending.

Of the total, 438 people work directly for the president. Under a shutdown, 129 could continue working, according to the contingency plan.

Biden, who has a staff of 24, would have had to make do with 12.

Obama’s national security staff of 66 would be cut to 42. Similar staff cuts would be imposed at the White House Office of Management and Budget, the Council on Environmental Quality, the Council of Economic Advisers and the Office of National Drug Control Policy, which are all part of the president’s executive office.

Mish concludes:

Fantastic Idea

If you think that a government shutdown is a fantastic idea (I sure do), then please contact your elected representatives and let them know.

But there are at least two other factors beyond simply wanting less government that may make a government shutdown and debt default attractive to the Tea Party wing.

The first of which is that the austerian worldview exemplified by the Wall Street Journal editorial page — in which large-scale deficit spending was expected to precipitate soaring interest rates and inflation — has largely been proven wrong by events. Interest rates and inflation have remained low. The Tea Party wing of the Republican Party now has an opportunity to try to make their initially wrong predictions come true by throwing the United States into default on its debt, and sending a message to markets and international investors that the US government and US Treasury debt is not a safe asset. Whether or not a government shutdown would actually result in a debt default (the Treasury would under such an eventuality likely prioritise debt service), and whether this would actually lift interest rates significantly are other matters, but shutting down the government and defaulting on the debt would certainly enforce austerity which is what the Republicans and especially the Tea Party wing want.

The second — and perhaps the greater factor — is the desire to prevent Obamacare taking effect. Now, I am not convinced that Obamacare can bring down healthcare costs as much as a Canadian-style or European-style system. Obamacare is certainly not an ideal system, although its earlier implementation in Massachusetts does appear to be fairly successful . But it does bring the United States much closer to something approaching universal coverage. With the message of the last Republican election campaign being that 47% of the population (the “takers”) is mooching off 53% of the population (the “makers”), Obamacare is seen by the Tea Party wing and probably the Republicans in general as the last turning point on the road to socialism. And avoiding the implementation of Obamacare is something that, I think, the Republican Party and especially the Tea Party wing will go all out to do.

Now, how far the Republicans are willing to go down this road remains to be seen. The more moderate wing may be willing to settle for a deal that avoids government shutdown in return for increasing the pace of austerity. But the impending implementation of Obamacare, and the general attraction of a government shutdown will strengthen the will of the Tea Party wing to not negotiate.

Personally, while I do think we are in the long run headed toward a world of increased decentralisation and a lesser state role (primarily as the result of technology), I don’t think a government shutdown will do anything to advance the cause of human liberty. In fact, I think a longer-term shutdown would probably end in civil unrest — a lot of people are dependent on government spending for income — and market turmoil (not least because markets seem to have priced in an easy resolution to the standoff). So the standoff will almost certainly end in a deal permitting a debt ceiling increase. How much carnage will occur before then remains to be seen.

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Bernanke vs Greenspan?

Submitted by Andrew Fruth of AcceptanceTake

Bernanke and Greenspan appear to have differing opinions on whether the Fed will monetize the debt.

Bernanke, on behalf of the Federal Reserve, said in 2009 at a House Financial Services Committee that “we’re not going to monetize the debt.

Greenspan, meanwhile, on Meet the Press in 2011 that “there is zero probability of default” because the U.S. can always print more money.

But they can’t both be true…

There is only 0% probability of formal default if the Fed monetizes the debt. If they refuse, and creditors refuse to buy bonds when current bonds rollover, then the U.S. would default. But Ben said the Fed will never monetize the debt back on June 3, 2009. That’s curious, because in November 2010 in what has been termed “QE2” the Fed announced it would buy $600 billion in long-term Treasuries and buy an additional $250-$300 of Treasuries in which the $250-$300 billion was from previous investments.

Is that monetization? I would say yes, but it’s sort of tricky to define. For example, when the Fed conducts its open market operations it buys Treasuries to influence interest rates which has been going on for a long time — way before the current U.S. debt crisis.

So then what determines whether the Fed has conducted this egregious form of Treasury buying we call “monetization of the debt?”

The only two factors that can possibly differentiate monetization from open market operations is 1) the size of the purchase and 2) the intent behind the purchase.

This is how the size of Treasury purchases have changed since 2009:

Since new data has come out, the whole year of 2011 monetary authority purchases is $642 billion – not quite as high as in the graph, but still very high.

Clearly you can see the difference in the size of the purchases even though determining what size is considered monetization is rather arbitrary.

Then there’s the intent behind the purchase. That’s what I think Bernanke is talking about when he says he will not monetize the debt. In Bernanke’s mind the intent (at least the public lip service intent) is to avoid deflation and to boost the economy – not to bail the United States out of its debt crisis by printing money. Bernanke still contends that he has an exit policy and that he will wind down the monetary base when the time is appropriate.

So In Bernanke’s mind, he may not consider buying Treasuries — even at QE2 levels — “monetizing the debt.”

The most likely stealth monetization tactics Bernanke can use — while still keeping a straight face — while saying he will not monetize the debt, will be an extreme difference between the Fed Funds Rate and the theoretical rate it would be without money printing, and loosening loan requirements/adopting policies that will get the banks to multiply out their massive amounts of excess reserves.

If, for example, the natural Fed Funds rate — the rate without Fed intervention — is 19% and the Fed is keeping the rate at 0%, then the amount of Treasuries the Fed would have to buy to keep that rate down would be huge — yet Bernanke could say he’s just conducting normal open market operations.

On the other hand, if the banks create money out of nothing via the fractional reserve lending system and a certain percentage of that new money goes into Treasuries, Bernanke can just say there is strong private demand for Treasuries even if his policies were the reason behind excessive credit growth that allowed for the increased purchase of Treasuries.

Maybe Bernanke means he will not monetize a particular part of the debt that was being referred to in the video. Again, though, he could simply hide it under an open market operations 0% policy or encourage the banking system to expand the money supply.

Whatever the case, if you ever hear Bernanke say “the Federal Reserve will not monetize the debt” again, feel free to ignore him. When he says that, it doesn’t necessarily mean he won’t buy a large quantity of Treasuries with new money created out of nothing.

Remember, Greenspan says there’s “zero probability of default” because the U.S. can always print more money. Does Greenspan know something here? There’s only zero probability if the Fed commits to monetizing the debt as needed. If Greenspan knows something there will be monetization of the debt, even if Bernanke wants to call it something else.

Greece Defaults

From Sky News:

The talking is over; it is finally happening. For the first time since World War Two, a developed nation is going into default.

That’s the significance of the events of the past 24 hours, with Greece’s debt being classified as in “selective default” and the European Central Bank banning it from its cash window. Months of planning by both banks and policymakers have gone into ensuring that Greece’s negotiated default will be a smooth painless process. We are about to find out whether that planning pays off.

Now, we shouldn’t be surprised by Standard & Poor’s decision to cut the rating on Greece’s sovereign debt from CC to SD (which stands for “selective default”). The ratings agencies had always said that, given private investors are about to lose just over half the value of their debt (through a complex bond swap), this downgrade would be a natural consequence.

Nor should we be shocked that the ECB says it will no longer accept Greek debt as collateral: in fact, the only surprise is that it’s taken this long – on the basis of the ECB’s previous policy, the bonds should have become ineligible when were first downgraded from investment status two years ago.

Peter Tchir thinks all the hullabaloo is a lot of sound and fury, signifying nothing:

So far there are no dramatic consequences of the Greek default. The ECB did say they couldn’t accept it as collateral, but national central banks (including Greece’s somehow solvent NCB) can, so no real change. We will likely get a Credit Event prior to March 20th once CAC’s are used to get the deal fully done. Will the market respond much to that? Probably not, though there is a higher risk of unforeseen consequences from that, than there was from the S&P downgrade.

It just strikes me that Europe wasted a year or more, and has created a less stable system than it had before. A year ago, Europe was adamant about no haircuts and no default. I could never understand why. Let Greece default, renegotiate terms, stay in the Euro and move on.

I suppose the magnitude of the problem depends on just which kind of credit event. And that mostly depends on how well-insulated the financial system is, and market psychology. A full-blown Lehmanesque credit shock? Who knows — certainly banks are fearful. Certainly, the problem of default cascades has been out in the open for a while. But most of the attempts to deal with the prospect of such things have mostly been emergency room treatment, and not preventative medicine — throwing liquidity at the problem. Certainly, it is possible the system is in a worse shape than 2008.

  1. The derivatives web is (nearly) as big as ever:
  2. There are still a myriad of European housing bubbles ready to pop.
  3. American banks are massively exposed to Europe.
  4. China’s housing bubble is bursting Surely their reserves will go into bailing out their own problems, and not those of Europe and America?
  5. Rising commodity prices — especially oil — are already squeezing consumers and producers with cost-push inflation.

Meanwhile, the only weapon central bankers have in their arsenal is throwing more money at the problem.

Will throwing more money at the problem work? Yes — in the short term. The danger is that creditor nations will not be prepared to throw enough to shore up balance sheets.

Will throwing money at the problems cause more problems in the long run? Yes — almost certainly.

Ultimately, we must look at preventative medicine — to stop credit bubbles expanding beyond the productive capacity of the economy. We should also look at insulating the economy from the breakdown of any credit bubbles that do form.

Austerity & Taxation

One of the main conclusions of — on the one hand — Austrian economics, and on the other, Modern Monetary Theory is that it is bad and dangerous for government to take more out of the economy than it puts in, i.e. running a surplus. The two schools of thought take this idea to different conclusions; Austrian economics advocates for far less government in recessions, whereas MMT advocates for greater deficit spending in recessions.

Basing my conclusions on the disastrous austerity contractions of the Bruning Chancellery, as well as contemporary Ireland and Greece, I have already railed quite strongly against the concept of austerity during a recession. Readers have (understandably) been quite sceptical. The position I am taking puts me in line with Professor Krugman, and various other Keynesian characters. And I agree that every dollar spent by the government must be taken out of the economy in taxation. And, government spending is often (but not always) plagued with problems such as regulatory capture, mismanagement and malinvestment.

But the evidence is clear — heavily indebted nations that slash spending and (as in the case of Greece today) raise taxes to “pay down debt” actually tend to experience not just greater economic contraction, but also increased deficits as tax revenues dip.

This was the American experience during the Great Depression. A great deal of attention has been given to “monetary inflexibility” (i.e. keeping the gold standard) as a “cause” of the depression, but very little attention has been given to the fact that Hoover drastically raised taxes and cut spending in 1932, just as the depression really started to bite:

The onset of the Great Depression in 1929 led to a sharp decline in tax revenues, as the economy contracted. President Herbert Hoover’s response was to push for a major tax increase. The Revenue Act of 1932 raised tax rates across the board, with the top rate rising from 25 percent to 63 percent. That increase was justified on the grounds that the budget needed to be balanced to restore business confidence. Yet the $462 million deficit of 1931 jumped to $2.7 billion by 1932 despite the tax increase. Interestingly, the major cause of the deficit’s rise was a sharp decline in income tax revenue, which fell from $1.15 billion in 1930 to $834 million in 1931, $427 million in 1932, and just $353 million in 1933.

The bottom line here is that it cuts both ways: just as cutting spending in a recession can deepen the problems, so too can raising taxes. This is because both of these things can push the nation to a position where government is sucking in more than it is pushing out. When the economy is contracting, the last thing it needs is a bigger net drain.

So the problem here is residual debt. Governments have lots of it. When leaders like Cameron, Papandreou and Merkel propose austerity, what they are actually proposing is paying down debt, much of which is held off-shore. Very often their commitments to cut are attached to a promise to raise taxes. This means that governments are committing to suck in more (sometimes much, much more) than they are paying out, which is by definition contractionary. If governments were to default on their debt, this would be a different story — governments could then maintain any kind of regime, statist or non-statist, without the problem of sucking more money out of the economy than they are disbursing. But right now — even with Iceland’s positive example — default is considered to be politically unachievable, particularly in regard to the larger states such the U.S. and the U.K.

So it is very clear that governments embarking on austerity policies are making precisely the same mistakes as the Hoover administration 80 years ago. And, of course, as revenues drop due to the punishing austerity, the situation will only get worse.

Default will become increasingly attractive for the advanced economies.

From the Economist:

Perhaps the most provocative paper comes from Jeffrey Rogers Hummel who reasons that default is virtually inevitable because a) federal tax revenue will never consistently rise much above 20% of GDP, b) politicians have little incentive to come up with the requisite expenditure cuts in time and c) monetary expansion and its accompanying inflation will no more be able to close the fiscal gap than would an excise tax on chewing gum. Most controversially, he argues that ”the long-term consequences (of default), both economic and political, could be beneficial, and the more complete the repudiation, the greater the benefits.”

Why does he take this view? Allowing for the Treasuries owned by the Fed, the trust funds and foreigners, total default could cost the US private sector about $4 trillion. In contrast, the fall in the stockmarket from 2007 to 2008 cost around $10 trillion. In compensation, however, the US taxpayer would no longer have to service the debt; their future liabilities would be lower.

After all, it has worked well so far for Iceland

The Inevitability of Default?

From Buttonwood:

While Greece continues to inch its way towards a [now completed] deal with its EU partners, the creditors of a much-larger debtor, the US government, appear to be untroubled. Ten-year Treasury bonds still yield just 2%. But the issue of how the US addresses its long-term fiscal problems is, as yet, unresolved. A series of papers from the Mercatus Centre at George Mason University in Washington DC, called “Tipping Point Scenarios and Crash Dynamics” attempts to address the issue.

Perhaps the most provocative paper comes from Jeffrey Rogers Hummel who reasons that default is virtually inevitable because a) federal tax revenue will never consistently rise much above 20% of GDP, b) politicians have little incentive to come up with the requisite expenditure cuts in time and c) monetary expansion and its accompanying inflation will no more be able to close the fiscal gap than would an excise tax on chewing gum. Most controversially, he argues that “the long-term consequences (of default), both economic and political, could be beneficial, and the more complete the repudiation, the greater the benefits.”

Why does he take this view? Allowing for the Treasuries owned by the Fed, the trust funds and foreigners, total default could cost the US private sector about $4 trillion. In contrast, the fall in the stockmarket from 2007 to 2008 cost around $10 trillion. In compensation, however, the US taxpayer would no longer have to service the debt; their future liabilities would be lower.

It’s nice to know I’m not just one lone voice in the wilderness.  But I think most readers already knew most of this. There is significant empirical evidence that when the problem is excessive systemic debt, neither austerity nor inflation are sufficient tools to really reduce the debt. Austerity tends to bring the problem to a head, while inflation tends to kick the can down the road. The latter may stabilise the system, but as we have seen in Japan, this does not necessitate recovery. If we want real debt erasure, we need measures that really erase debt.

By building a new system we can open a window onto whole new world of possibilities for reform. One possibility is the return of Glass-Steagall-style separation between investment and retail banking, and a complete ban on complex derivatives contracts.

And there is nothing morally wrong with default. Investors in government debt should do their due diligence, and be aware that for all the political bleating and obsequious promises from politicians, ratings agencies and Warren Buffet there is always a risk of default with sovereign debt. Debt is only ever as good as its issuers ability to generate sufficient revenues.

There was never any guarantee that this era of unrestrained credit creation, globalisation, job migration and American imperialism could go on forever.

The System is the Problem

From the BBC:

US credit ratings agency Moody’s has put the UK on negative outlook, meaning it thinks there is more chance the economy may lose its triple A status.

France and Austria, who also share a top triple A rating, have been similarly graded. Italy, Spain and Portugal’s ratings have been lowered.

Moody’s blamed the eurozone crisis for the adjustments.

The UK chancellor remains committed to his policy of austerity whilst the opposition warns this could backfire.

The negative outlook for the UK means Moody’s thinks there is a 30% chance of a downgrade within 18 months.

BBC economics editor Stephanie Flanders said there was no suggestion that the agency would prefer the UK government to change its economic policy of austerity.

Now, I believe that the idea that a Western government bond can today be a AAA investment is very dubious. Simply, the current phenomena of negative real interest rates and debt saturation, and the problems of deleveraging mean that it is very unlikely that an investor in government debt will get back their purchasing power: either by inflation, or by default, most such investors in the next decade will probably lose the skin on their noses. But that is a side issue.

Since David Cameron and George Osborne announced their policy of austerity, my thinking on fiscal policy has somewhat evolved. Given that we know that a high residual debt load has a damaging effect on growth, my view has always been that we need to reduce the debt load as fast as possible. The question was always how we should best go about doing so. I knew from the beginning that there was always a danger that in an economy already dependent on high government expenditure, fast and hard cuts — especially in an already-depressed economy — would probably lead to a contraction in tax revenues, thus producing higher deficits and less debt reduction.

This prospective problem has been expressed quite well in this graph:

Furthermore, because of the high residual debt load, cuts in spending would merely go toward paying down debt. This means that the government will still be sucking just as much capital out of the economy as before. While cutting taxes might prove a huge plus , the presence of a huge debt load means tax cuts will be unaffordable, and thus there would be no such boost.

The greater problem, of course, is that in an economy that is greatly centralised around government, cutting spending very often translates into cutting real output, and real economic activity. Now during an economic boom, this is fine — the growing market can pick up the slack. But during an economic contraction, this just takes the problem of falling output and exacerbates it.  One only has to look so far as Germany under Heinrich Brüning,( or the problems currently afflicting the Euro Zone) to understand the problem:

Bruning applied the [austerity] medicine to Germany, and the resulting backlash was so intense he suspended parliamentary democracy and ruled by emergency decree, setting a fine example for the next guy who took power. After just two years of “austerity” measures, Germany’s economy had completely collapsed: unemployment doubled from 15 percent in 1930 to 30 percent in 1932, protests spread, and Bruning was finally forced out. Just two years of austerity, and Germany was willing to be ruled by anyone or anything except for the kinds of democratic politicians that administered “austerity” pain. In Germany’s 1932 elections, the Nazis and the Communists came out on top — and by early 1933, with Hitler in charge, Germany’s fledgling democracy was shut down for good.

Of course, in the modern world there is a larger problem even beyond fiscal contraction leading to a contraction in real output. This is the problem of fiscal contraction leading to financial collapse. Simply, as Greece have enacted more and more austerity, they have collected less and less taxes. And this means that they are closer to closer to default. Now, because Greece’s debts have been securitised and spread around the European banking system, a default on Greek debt could lead to mass bank insolvencies in European, which could lead to mass bank insolvencies around the world as more and more counter-parties default on their obligations.

As I wrote last month:

As we learned a long time ago, big defaults on the order of billions don’t just panic markets. They congest the system, because the system is predicated around the idea that everyone owes things to everyone else. Those $18 billion that Greece owes might be owed on to other banks and other institutions. Failure to meet that payment doesn’t just mean one default, it could mean many more.

That is known as a default cascade. In an international financial system which is ever-more interconnected, we will soon see how far the cascade might travel.

This is a bizarre situation. The intuitive response to excessive debt — belt-tightening; spending less, and saving more — is not only wrong, but it is potentially dangerous.

Modern Keynesians believe that the answer to these problems is stimulus and monetary expansion: that government ought to increase spending, and that monetary authorities ought to print more money. Essentially, both of these ideas amount to reinflating the bubble. Stimulus allows for the economy to keep ticking over while the private sector deleverages. Money-printing and inflation shrinks the debt relative to the amount of money in the economy. There is a real advantage here: bondholders — as opposed to taxpayers — take a hit as their lendings are repaid in debased currency. As I have noted in the past, I believe (as did Jesus) that creditors are the ones who ultimately must take the hit when it comes to addressing the problem of debt saturation. After all, in a market economy, all investments — even those made to very wealthy debtors — carry risk. Unfortunately, the inflationary Keynesian method hits savers and investors, and those living on a fixed income.

Worst of all, these aids ignore the real problem, which is not the recession at all, but the thing that caused it — the huge preceding credit-fuelled bubble. And therein lies the problem.

As I wrote way back in October:

Modern economics has been a great experiment:

 

Economic history can be broadly divided into two eras: before Keynes, and after Keynes. Before Keynes (with precious metals as the monetary base) prices experienced wide swings in both directions. After Keynes’ Depression-era tract (The General Theory) prices went in one direction: mildly upward. Call that a victory for modern economics, central planning, and modern civilisation: deflation was effectively abolished. The resultant increase in defaults due to the proportionate rise in the value of debt as described by Irving Fisher, and much later Ben Bernanke, doesn’t happen today. And this means that creditors get their pound of flesh, albeit one that is slightly devalued (by money printing), as opposed to totally destroyed (by mass defaults).

But (of course) there’s a catch. Periods of deflation were painful, but they had one very beneficial effect that we today sorely need: the erasure of debt via mass default (contraction of credit means smaller money supply, means less money available to pay down debt). With the debt erased, new organic growth is much easier (because businesses, individuals and governments aren’t busy setting capital aside to pay down debt, and therefore can invest more in doing, making and innovating). Modern economics might have prevented deflation (and resultant mass defaults), but it has left many nations, companies and individuals carrying a great millstone of debt (that’s the price of “stability”):


The aggregate effect of the Great Depression was the erasure of private debt by the end of World War 2. This set the stage for the phenomenal new economic growth of the 50s and 60s. But since then, there’s been no erasure: only vast, vast debt/credit creation.

And that is the real problem we face today: the abolition of deflation, the abolition of small defaults, the abolition of the self-correcting market.

Neither austerity, nor stimulus are a sufficient remedy for today’s financial problems (let alone today’s economic ones). What is needed is liquidation, so that the old rubbish is cleared out, the system is no longer congested by debt saturation, and new opportunities are opened up.

Simply, everything we have experienced over the last twenty years — from Japan in the ’90s, to America in ’08, to the ramifications of Greece’s default, to the growing trade war between America and China — is a lesson that credit-based money is not robust. It is so weak to the problem of credit contraction that — once the point of debt saturation is inevitably reached — every time there is a contractionary event, monetary authorities must pump the market with new money, and highly-indebted governments must (unless they are foolish like Britain’s present government, and want to see falling consumer confidence, business confidence, real GDP, industrial output, and productivity) maintain or increase spending instead of reducing spending and saving money. Otherwise, the system itself is endangered. It is a fundamentally fragile system. 

Ultimately, nature always wins. Ultimately, the debt saturation problem will be taken care of either by currency collapse, or by defaults (and probably systemic collapse, and a new global financial order), or by war, or by some kind of debt jubilee. I don’t know which. I hope for the latter. It seems kinder.

Did Cameron Just Kill the Euro?

I find it hard these days to praise any establishment political figure. Too often their actions are devoid of principle, too often their words are hollow, and too often their demeanour smacks of a rank ignorance on matters of economics and liberty.

And undoubtedly, Cameron’s austerity policies are not sound. As I have noted in the past, the time for austerity at the treasury is the boom, not the slump.

But today David Cameron seems to have bucked that trend.

From the BBC:

David Cameron has refused to join an EU financial crisis accord after 10 hours of negotiations in Brussels.

Mr Cameron said it was not in Britain’s interest “so I didn’t sign up to it”.

But France’s President Sarkozy said his “unacceptable” demands for exemptions over financial services blocked the chance of a full treaty.

Britain and Hungary look set to stay outside the accord, with Sweden and the Czech Republic having to consult their parliaments on it.

A full accord of all 27 EU members “wasn’t possible, given the position of our British friends,” President Sarkozy said.

There is an obvious fact here: scrabbling to reach an agreement in the interests of political and economic stability — which is exactly the path Japan has taken for the past 20 years, and America for the past 3 — allows broken systems to continue to be broken. All this achieves is more time to address the underlying issues, which as we are discovering is something that does not happen, because markets and policy makers fool themselves into believing that the problems have been “solved”, and that there is “recovery”.

Cameron’s intransigence could well be the spark that Europe — and perhaps even the globe — needs to degenerate to the point where the necessary action — specifically, some kind of debt jubilee — can occur.