How misplaced fear of Greece could lead us on a path more like Japan's.

My best guess is there will be little or no fight over the debt ceiling extension. I think the President will agree to pretty much whatever the Republicans want, and get more than enough Democrats to join him.

Best I can tell, the entire Congress agrees the deficit is a long term problem that absolutely must be addressed. The only arguments against 'fiscal consolidation' that I've see are the 'bleeding heart' arguments which don't cut it when everyone believes that Greek-type insolvency looms -- despite plenty of evidence to the contrary.

Also, the ball is in the Republicans' court, as they can't just be against raising the debt ceiling. So it will be up to them to take the lead and offer terms and conditions for their votes, after which enough Democrats will pretty much agree to it all, including cuts in Social Security and Medicare expenses, of one type or another, current and future.

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All of which dooms the US economy to suffer from a severe lack of aggregate demand for the foreseeable future. As my friend Warren Mosler has pointed out in his book "The 7 Deadly Innocent Frauds of Economic Policy": The actual act of Government spending is NOT operationally limited or in any way constrained by taxing or borrowing. Debt or no debt, our children get to consume whatever they can produce. There is no "intergenerational theft". Government budget deficits add to savings; they don't detract from them. Social Security is not "broken" and government checks don't "bounce". The trade deficit is NOT an unsustainable imbalance that takes away jobs and output, so long as fiscal policy is deployed in support of higher incomes and growth. Jobs are lost because taxes are too high for a given level of government spending, not because of imports. Budget deficits build productive infrastructure, which exerts a positive influence on economic growth.

Meanwhile, budget deficits typically help stimulate investment because they keep aggregate demand from plummeting and thereby help to sustain employment. So any moves to cut spending in order to keep us under an arbitrary, self-imposed legal debt ceiling will simply add to our deficit, because governments can control spending levels, BUT NOT DEFICIT LEVELS.

Bottom line -- believing we could be the next Greece continues to keep us on the path of becoming the next Japan.

Marshall Auerback is a Senior Fellow at the Roosevelt Institute, and a market analyst and commentator.

**For more, see Auerback's ND20 posts: "Whatever Happened to Japan" and "Repeat After Me: The U.S. Does Not Have a Greece Problem".

Get ready economists: your help is not just needed domestically. At a recent event put on by the Roosevelt Institute's Next American Economy, Senior Fellow Bo Cutter introduced his audience to Les Gelb, an expert in foreign affairs. "The world has changed," Gelb warns. "It now revolves primarily around economics." Global power used to be about military might and land wars. But not anymore. "For the first time in history, we have a global power that isn't a military power" -- that would be China -- which is a "third-rate military power," he says. In fact, the power has shifted for most of today's major players -- economic prowess has buoyed the likes of Turkey, Brazil, and India.

Interview :: Leslie Gelb from Roosevelt Institute on Vimeo.

What does this mean for the US? "The US isn't really adjusting" to this new world, Gelb warns. We're overly focused on a war in Afghanistan and not on economic relations with countries like Mexico. Our spending on defense is "out of proportion" and it means "we think about our interests and activities in the world in military terms." And we have a pretty screwed up economy at home to boot.

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So what's the solution? The US must "shift the focus to foreign affairs. We're losing influence all the time," he points out. And as we refocus, we must also combine the study of foreign affairs with economics. We also have to get our own economic house in order. "That is the absolutely essential ingredient of foreign policy," Gelb says. But he warns that "figuring out policy is the easy part. Bringing it about is the hard part." We're not intellectually prepared to cope with the changes this will require. So implementing his advice will be tough.

What happens if Germany decides it wants its money back? If aggressive fiscal policy isn't the answer, things could get ugly.

Like marriage, membership in the euro zone is supposed to be a lifetime commitment, "for better or for worse". But as we know, divorces do occur, even if the marriage was entered into with the best of intentions. And the recent turmoil in Europe has given rise to the idea that the euro itself might also be reversible and that one or more countries might revert to national currencies.

As far as the European Monetary Union goes, the prevailing thought has been that one of the weak periphery countries would be the first to call it a day. (In Ireland's situation, one could make a good case for it on the grounds of persistent spousal abuse.) It may not, however, work out that way: all of a sudden, the biggest euro-skeptics are not the perfidious English, but the Germans themselves. Take a look at these headlines (kindly drawn to my attention by James Aitken of Aitken Advisors, LLP): "Germany and the euro: We don't want no transfer union" on The Economist, "Jenkins: Where Are the Business Europhiles Now?" on WSJ.com, and even a book by Hans-Olaf Henkel, formerly of IBM (Germany) and hitherto one of Germany's great euro-enthusiasts (English translation), "Return our Money".

So let's consider what happens if Germany decides to follow Herr Henkel's advice. On the plus side, given Germany's historic reputation for sound finances, the country will likely emerge with a strong Deutschmark. But this will likely come with a huge cost: Germany will probably save its banking system at the expense of destroying its export base. The newly reconfigured Deutschmark will soar against the euro and become the ultimate safe haven currency for speculators keen to find a true store of value. This will mitigate the write-down impact of the inevitable haircuts on euro-denominated debt, because the euro (assuming it is retained by the remaining countries) will fall dramatically. Even if the euro itself vaporizes, the Germans will simply pay back debt in the old currencies, likely at fractions of their previous value.

But Germany's external sector will be wiped out. The resultant appreciation of the new Deutschmark, along with the inevitable banking crisis in the periphery (which will exert significant deflationary domestic pressures in other countries and therefore reduce consumer demand) will engender a huge trade shock. Germany's growth will slow dramatically, as exports comprise such a large proportion of GDP.

Another interesting byproduct: By accounting identity, a fall in Germany's external surplus means a large increase in the budget deficit (unless the private sector begins to expand rapidly, which is doubtful under the scenario described above). So Germany will find itself experiencing much larger budget deficits.

Let's elaborate a bit further. My friend Randy Wray wrote a very interesting blog post last year entitled "Teaching the Fallacy of Composition: The Federal Budget Deficit", where he used the standard sectoral balance approach to show that:

At the aggregate level, the dollar spending of all three sectors combined must equal the income received by the three sectors combined. Aggregate spending equals aggregate income. But there is no reason why any one sector must spend an amount exactly equal to its income. One sector can run a surplus (spend less than its income) so long as another runs a deficit (spends more than its income).

And,

if we have a balanced foreign sector, there is no way for the private sector as a whole to save unless the government runs a deficit. Without a government deficit, there would be no private saving. Sure, one individual can spend less than her income, but another would have to spend more than his income.

So the spending-income relationships between the three sectors, which can be expressed in terms of the sectoral balance accounting framework, are binding on each individual sector.

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This is important when we consider Germany's fiscal policies in the context of a situation in which its trade surplus quickly dissipates. Remember, this is not high Keynesianism, but simple double entry bookkeeping, developed some 6 centuries ago. Call it the tyranny of Accounting 101.

We know that if the government sector tries to run surpluses when there is an external deficit and the private domestic sector wants to save, you'll get much slower growth and much higher unemployment. The fiscal drag reduces spending power, which damages output and income growth and ultimately forces the private domestic sector to run down its wealth holdings. The only way to offset this damage  is to have a greater external surplus (net exports) that adds spending to the local economy and supports income growth and the desire to save. That is the situation today in several Asian countries and Norway. If the private domestic sector saves and the nation enjoys an external deficit, the only way this can be sustainable is through continuous budget deficits. They should be ongoing and scaled to match the spending gap left by the other sectors.

In the current German situation, although the country runs a large current account surplus, it is insufficient to offset a high private sector predisposition to save (which means there is some deficit). But the current account surplus does allow for a smaller budget deficit than its so-called "profligate" Mediterranean neighbors, while still facilitating the private domestic sector's desire to save. As I have argued before, it is the "profligacy" of Germany's Mediterranean trading partners that has allowed it to rack up huge current account surpluses and therefore run smaller budget deficits than the PIIGS countries.

Germany will regain its fiscal freedom once divorce from the euro is complete. This itself is something the Germans should celebrate, providing their government takes advantage of it. Remember, once it returns to the Deutschmark, Germany becomes the issuer as opposed to the user of a currency, as is the case under the euro, and is fully sovereign in respect of its fiscal and monetary policy. Consequently, it can offset the external shock by running large government budget deficits, which will add new net financial assets to the system (adding to non-government savings) available to the private sector.

It will become almost impossible to run budget surpluses under this scenario, but this isn't bad for any country that issues debt in its own free-floating non-convertible currency. As unpalatable as this conclusion might be for many, it is entirely consistent with national income accounting. As Bill Mitchell has pointed out on many occasions:

[T]he systematic pursuit of government budget surpluses (G < T) is dollar-for-dollar manifested as declines in non-government savings. If the aim was to boost the savings of the private domestic sector, when net exports are in deficit, then taxes in aggregate would have to be less than total government spending. That is, a budget deficit (G > T) would be required.

A budget deficit per se, then, will not cause any problems for Germany, as it will no longer have any external constraint after it restores the Deutschmark as its currency of choice. But Germany has historically embraced an export-based model at the expense of curbing domestic consumption.

So its policy makers face a choice: will the country offset the decline in its current account surplus via a more aggressive fiscal policy by choice (i.e. proactively, in search of a full employment policy), or reactively, via growth in the automatic stabilizers? If the German economy slumps (as I expect it will), the deficits created by automatic stabilizers will rise as a matter of course. Germany can easily counter that if it chooses to do so.

It's never a laughing matter to see any economy slump. But anyone with a sense of irony will naturally be wondering whether the German government and its voters will get themselves in a frenzy about being so "profligate" as the inevitable trade shock develops. I suspect there will also be a touch of "schadenfreude" on the part of its recently divorced euro zone "ex-spouses". (How does one say "schadenfreude" in Greek or Spanish?) Personally, I've never seen the merits of eliminating government debt just so that the private sector is forced to go into greater deficit, and perhaps the Germans will eventually figure that out as well. In any case, one suspects that we are about to get a nice "teachable moment" for Frau Merkel if Germany does embrace the course of action now so enthusiastically endorsed by the likes of Herr Henkel.

But the country might well find truth in the adage, "Be careful what you wish for."

Marshall Auerback is a Senior Fellow at the Roosevelt Institute, and a market analyst and commentator.

Despite a blame-a-thon on Ireleand,  Germans banks are really at the core of the eurozone catastrophe.

Much ink has been spilled in the press over the Irish problem and the laxity of the country's southern Mediterranean counterparts in contrast to the highly "disciplined" Germans. But perhaps we have to revisit that caricature. Not only has the Irish crisis blown apart the myth of the virtues of fiscal austerity during rapidly declining economic activity, but it has also illustrated that Germany's bankers were every bit as culpable as their Irish counterparts in helping to stoke the credit bubble.

One of the traditional rationales for the creation of the euro was that a single currency and strict Maastricht criteria would keep the profligate Mediterraneans and their Celtic equivalents in line. Instead, critics, particularly in Germany, increasingly see the European Monetary Union as a means for freeloading nations to offload their liabilities onto fitter neighbors.

Not surprisingly, this has engendered much discussion that perhaps it would serve Germany's interests to leave the euro, rather than booting one of the Mediterranean "scroungers" out. But as Simon Johnson has pointed out, this comforting narrative of German prudence matched up against Irish profligacy doesn't really stack up:

German banks in particular lost their composure with regard to lending to Ireland -- although British, American, French and Belgian banks were not so far behind. Hypo Real Estate -- now taken over by the German government -- has what is likely to be the highest exposure to Irish debt.

But look at loans outstanding relative to the size of their domestic economies (using the BIS data on what they call an "ultimate risk basis").

German banks are owed $139 billion, which is 4.2 percent of German G.D.P. [my emphasis]

Where were the German regulators? As my colleague Bill Black has noted:

They seem to have believed that ‘What happens in Vegas (Dublin) stays in Vegas (Dublin).' Instead, their German banks came back from their riotous holidays in the PIIGS with BTDs (bank transmitted diseases). The German banks' regulators continue to let them hide the embarrassing losses they picked up on holiday, but that cover up will collapse if any of the PIIGS default. The PIIGS will default if the EU does not bail them out, so there will be a bail out even though the German taxpayers hate to fund bailouts.

German banks' relatively high exposure to Ireland does pose the question as to whether there is some wild, Weimar-style hyperinflationista lurking deep in the heart of every German, only able to express itself fully when away from the prying eyes of fellow citizens.

All of the rescue plans that have been introduced in Ireland or Greece thus far rest on the assumption that, with more time, the eurozone's problem children could get their fiscal houses in order -- and Europe could somehow grow its way out of trouble. But the fiscal austerity being offered as the "medicine" is turning out to be worse than the disease. It has exacerbated the downturn and unleashed a horrible debt deflation dynamic in all of the areas where it was reluctantly implemented.

But here's the thing: these fiscal straitjackets obscure the history of how we came to today's horrible impasse and, more specifically, the German banks' role in helping to fuel the credit binge. Also lost is the reason why this has metastasized into a far greater crisis: as part of the eurozone, Ireland does not have the fiscal freedom to come up with a sufficiently robust government response. The UK had a comparable real estate bubble in the late 1980s, which culminated with the Soros attack on the pound in 1992 and the ejection of sterling from Exchange Rate Mechanism (the precursor to the EMU). This was a blessing in disguise. Withdrawal from the ERM saved the UK because it allowed the country sufficient latitude to reflate. Yes, the country had a major recession (in many ways a consequence of the surrender of fiscal freedom as a result of joining the ERM in the first place), but there was never a systemic risk that posed a threat to the country's overall solvency as is the case in Ireland today. And this is exacerbating the problem in Ireland because it persists in chasing its tail repeatedly with futile fiscal austerity measures.

The truth of the matter is this: the eurozone seems rotten to the core, literally. Germany represents that core. The Germans might occupy the penthouse suite, but it is the suite of a roach motel. And we know what happens to those who enter such "establishments."

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Yes, longer term the problems currently afflicting the eurozone could be sorted via the creation of a supranational fiscal authority -- a "United States of Europe". But with each crisis (Ireland today; Portugal and Spain tomorrow; Italy and then France next?), the political forces are coalescing in a radically different direction. The Germans are becoming increasingly resentful as they perceive their country as the bailout mechanism of last resort (even though the Irish experience suggests that their bankers are also guilty of many of the same excesses as the "Celtic Tiger"). The PIIGS themselves are seeing that the benefits of euro membership have been vastly overstated and in fact now act as a cancerous influence through the Germanic embrace of austerity. (Paradoxically, it has been the "profligate" behavior of those so-called lazy Mediterraneans that has enabled Germany to retain its export-driven model, as well as allowing it to run lower budget deficits than most other countries.)

The eurozone could ultimately end up like Yugoslavia writ large. Prior to the break up of that country, the relatively rich republics, Slovenia and Croatia, resented policies that transferred wealth to the poorer republics like Serbia, Macedonia, Montenegro, or the autonomous region of Kosovo. Once Tito's organizing genius disappeared, the links stitching the country together became frayed and eventually snapped as old grievances manifested themselves in newer forms. The same could happen to the Europe Union if it underwent a supranational fiscal union -- the beginnings of which are already in evidence. I think the Germans are beginning to recognize that, which is why there is discussion about leaving the euro.

But let's first be clear: German Chancellor Angela Merkel has persistently argued that it is essential that private investors, notably the bond holders, begin to suffer losses so that they will have the proper incentives to provide effective "private market discipline" going forward. She has further argued that it is fair that they suffer losses, given the premium yields they received and their lack of due diligence. That's an honorable policy. But it's like the old Irish joke of the driver who gets lost, asks for directions, and is told, "Well, I wouldn't be starting from here." By the same token, Ireland clearly illustrates that German banks, as well as their Mediterranean counterparts, would be big losers under the Merkel proposal. Ironically, German financial institutions could find themselves subject to the same kinds of bailouts that Chancellor Merkel and many of her counterparts in Berlin are urging on the Irish and Greeks.

As always, leave it to the Irish to come up with the most poetic response to the crisis. True, W.B. Yeats did not live to see this disaster, but his passionate "September 1913" does evoke the tragedy of today's Ireland and the futility of the current policy responses for their people (and beyond):

Was it for this the wild geese spread
The grey wing upon every tide;
For this that all that blood was shed,
For this Edward Fitzgerald died,
And Robert Emmet and Wolfe Tone,
All that delirium of the brave?
Romantic Ireland's dead and gone,
It's with O'Leary in the grave.

Graves that might soon include not only the O'Learys, but also the Garcias, Texeiras, Moreaus, and Schmidts if a more rational course of action throughout the euro zone is not adopted soon.

Marshall Auerback is a Senior Fellow at the Roosevelt Institute, and a market analyst and commentator.