So far I’ve focused my attention on the economic and commercial aspects of the Broken World. But there’s more to life than money.

Unless you are living at the subsistence level, which is a very real problem for many people in many countries, not limited to developing nations or failed states.

Slow growth and economic stress have other implications. When the global economy was growing, albeit through the application of ever increasing debt, people were more cooperative and happy to share. Selfishness is not just bad in a moral sense, it often leads to the violation of certain rationality axioms and folk theorems which economists rely on to explain economic behavior. Violate these axioms and the implications for economic efficiency can be unpleasant or unpredictable.

An example is dividing the dollar, a hypothetical game that tests the player’s adherence to the axiom of irrelevant alternatives. A certain meanness quickly violates this axiom and leads to sub optimal outcomes.

One can expect, in these times of economic famine, that:

1. People are less likely to share.
2. They are more likely to pursue relative advantage than absolute well being, and can therefore be purposefully obstructive.
3. They will be less cooperative, which is a generalization of the above.
4. Beggar thy neighbour policies and trade wars are more likely to arise. 
5. At a time when governments and leaders are most needed to fix the system, policy mistakes are high.
6. Conflict may extend beyond economic and commercial, to strategic and martial.

 These are not only difficult times, they could be dangerous times.

The US economy is quite evidently slowing again and the Fed in its wisdom has decided to extend Operation Twist, that is buying longer dated treasuries and funding that with the sale of shorter dated debt. This is like someone saying he’s got to water the lawn just after Hurricane Katrina.

 Hasn’t anyone at the Fed noticed the frantic buying of treasuries by anyone whose limbic brain has triggered its ‘run for your life’ algorithm?

A few smart investors will attempt to front run the Fed, and equity valuations will get even cheaper, so there will be support for the bond and equity markets, but for employment and growth, OpTwist is pushing on a very slack string.

For the real economy, the government has all but led the horse to the water and watched in bewilderment as it has refused to drink. Its time to shove the animal’s head in the water, hold its nostrils shut and force some liquids down the emaciated beast’s neck. This means fiscal policy, and not just any old broad brush fiscal policy; targeted fiscal policy. Any deficit strategy at this stage will be punished. OpTwist should be used in conjunction with OpDrip, to reorganize the debt profile of the government in preparation for some deficit strategy.

Deficit strategy? At a time like this? Only a madman would suggest that! Well, all the rational people have thrown their collective wisdom at the problem and come up empty. Let’s try something different.

Its time to stop encouraging investment and consumption; its time to punish non-investment and non-consumption. The tax code is a useful place to start.

All this is brinksmanship of course, you know, a deficit strategy in the midst of a sovereign debt crisis. Its more of an emergency measure really. But guess what… Its an emergency.

The financial crisis rolls on. Failure to fully understand the first precipitation in 2008 is leading to errors in policy.

For example, Greece’s insolvency is not the consequence of the GFC, it was exposed by it. Spain’s sovereign balance sheet is unhealthy but not terminal, its banks’ are. Similarly, Ireland fell for its banks. In both cases, real estate bubbles bursting were the root cause.

A greater principle is at stake, our model of capitalism. In its original form, capitalism was the disinterested arbiter of fortune and failure, symmetrical in reward and punishment. Since the early 1990s, and coincident with the demise of that dour alternative, communism, central banks and governments have come to favour reward, to the extent that an important element of capitalism, its natural selection, has been blunted. This is risky.

Just as the trader in the bank may win big but only lose his job (and not his own capital), so an asymmetrical regime encourages excessive or ill considered risk taking. With interest rates also a hurdle in the investment decision, lowering interest rates to bail out entire economies distorts price signals important in the allocation of risk capital.

Today’s capitalists are socialists on the downside. Governments and regulators are spoiling a generation by sparing the rod. They are also weakening the breed. Many of the emerging market entrepreneurs are thriving against their western counterparts because fate has been a cruel teacher, because decades of corruption and expropriation by despotic regimes have steeled their resolve.

The Euro zone is but one manifestation of the dilemma. Saving Greece will encourage Italy, Spain et al to heave a sigh of relief and slide back into fiscal irresponsibility. And to what end? Saving Greece will require the combined Eurozone to bail out Spain and Italy. The Spaniards have already got themselves a head start with ‘not a bailout, but a loan with favorable terms.’ Terms which Ireland, Portugal and Italy are now studying with much interest. To renege. 

The Euro group has two feasible paths to take, neither of which it has contemplated. The first is to let the lame ducks die, which is very un-socialist and will never find political support. The second is a system wide bailout sufficiently comprehensive that it ends the uncertainty that has plagued markets since summer 2010. 

The current strategy of staving off disaster as and when it threatens is not viable. It means that the problem continues to grow while a solution keeps getting deferred.

The combined financial might of Germany is insufficient to recapitalize the rest of Europe, so debt monetization is a necessary intermediate step. The ECB will need to monetize member countries’ debt across the board. This is bad news for the Euro and risks inflation in the Eurozone.

Europe will require financial assistance on the scale and complexity of the Marshall Plan. It is hard to see which economy is sufficiently strong to provide such financial assistance given the global scale of the 2008 financial crisis. It is hard to see a way out.

Animal spirits need to be revived, but how. Monetary policy today is pushing on a string. Fiscal policy is unfeasible given the state of public coffers. Debt levels are simply too high. Much of the public debt was previously private. Government’s in an attempt to save the system assumed these debts, shoring up private balance sheets, whose principal’s today are shy of spending or investing. Keynes’ prescription would have been to spend on their behalf, yet perversely, the wherewithal to do so has been transfered away to them. Without investment and consumption, and thus growth, taxation to fund expenditure is futile. Perhaps expropriation is a last desperate strategy. It is sometimes necessary to nationalize the weak, but perhaps it is useful to nationalize the strong. If the idea is to tax and spend.

Macro prudential policies can be deployed to address the dual problem, encouraging investment and consumption. A tax on corporate net cash is a means of encouraging investment. Taxing earnings after capex is another. Pro growth policies involve reducing marginal taxation which with sovereign balance sheets in their current precarious state will be hard justify. They will be regarded as brinksmanship.

To recap.

Monetary policy is ineffective but must be undertaken as part of debt monetization. Austerity is self defeating but some measure needs to be done to quell market fears. Growth is the way forward but requires some brinksmanship. And Europe needs a system wide bailout.

The problem of fiscal union in the Eurozone is not as intractable as many think. There is an elegant solution. Actually, let me retract that, there is a chaotic, potentially contentious, precipitous, union breaking, gut wrenching solution. Which is quite nice.

What the Eurozone members’ require is disinterested, rational management of fiscal policy. Arguably, no country can separate fiscal policy from politics and special interests. There is another way.

The Germans will manage fiscal policy for Italy and vice versa. France will be paired with Spain, Netherlands with Belgium, Austria with Portugal, Greece with Finland,  Slovakia with Slovenia and Ireland with Luxembourg. Hmmm, what do we do with Malta? Cyprus manages Estonia which manages Malta which manages Cyprus.

It will be lots of fun, reuniting old friends and lovers.

Threat of mutual mass destruction will keep everyone in line. No one has an incentive to do the other harm.

It will never happen but if ever there was the will for greater union, this would be an entertaining start.

It is irrational to establish or maintain a common currency in Europe. If, however, the decision was based on ideology, then the policies designed to hold together the cracked and bursting union are misguided.

Many of the Eurozone’s countries are insolvent to the extent that every bond they issue must be considered a PIK. These countries will surely face higher refinancing costs as investors flee and traders attack.

Each country has now been put on notice that some form of austerity and reform is necessary. Both austerity and reform are nice words for nasty things. Without a currency to make the price adjustments, domestic factor prices, such as wages, must bear the brunt.

As desperation and internal politics, not least an unruly public, drives countries to the brink, discipline needs to be instilled.

The Spanish bank bailout was ill advised. Any bailout is ill advised. At this point bailing any country out will only encourage solvent or marginal economies to seek a bailout or at best renege on their fiscal responsibilities.

An opportunity exist(ed) in Greece. Here is an economy which is not sufficiently integrated into the core Eurozone that its ejection would cause the minimum (of any other Eurozone country) of chaos.

A single exit is necessary (and may not be sufficient) to hold the union together. Greece is a convenient candidate. It should be forcibly removed from the union and denied any bailouts or transfers. The indictment of Greece will serve as a stern signal to Spain, Italy and Ireland, that non-compliance and fiscal irresponsibility has a high price. That price must be sufficiently high to compensate for the contagion risk associated with the ejection of a member state.

Following such drastic action, a more measured approach can be taken to cementing the union. Fiscal union or a banking union will need to be established. That is another long and painful discussion.