Revisiting the Modest Proposal: Q&A with a Skeptic – Fall 2014 version (*)

By Yanis Varoufakis, a professor of economics at the University of Athens. Cross posted from his blog

As Europe seems resigned to the perpetuation of the Euro Crisis, with its authorities in a state of permanent paralysis (with only the ECB trying, and failing, to stem the debt-deflationary vortex), it seems more pertinent than ever to keep the debate on the Modest Proposal going. If only as a reminder to the powers-that-be that there are immediately implementable policies whose implementation would stem the crisis without breaking any of the existing rules, without having the core countries pay one euro for the debts and losses of the periphery, and without any further diminution of national sovereignty. Can all this be possible? Is the Modest Proposal genuinely capable of delivering such much-needed relief at no cost and without bypassing any of the existing rules? We, the authors of the Modest Proposal, think so. Of course, sceptics have every right to pose questions and challenge our hypotheses. In this post, one such sceptic asks pertinent, probing questions about each of the Modest Proposal’s four policies. Which we do our best to answer. [(*)For earlier Q&As on the Modest Proposal, raising many of the same issues, click here and here.) Read on…

Banking Crisis (Policy 1)

Does the step-by-step bank recapitalisation (recommended by Policy 1) not contradict a basic tenet of existing Treaties, contrary to the Modest Proposal’s claim that it stays within existing rules and Treaties? Will the ESM not suffer losses?

Of course there will be losses. Resuscitating bankrupt bankers will always come at a loss. But not of the ESM. Indeed, judging by historical precedent, the ESM should have no difficulty returning a (small) profit to the European taxpayer.

Let us look at these historical precedents. Indeed, the Modest Proposal’s idea here is neither new nor untried. In effect, we are suggesting that the ESM should function like TARP did in the US (after 2009), like the Swedish, Finnish and Norwegian Banking Authorities in 1992, indeed like the Banking Authority of South Korea in 1998. In all these instances (that followed massive financial sector collapses), the public bank bailout fund stepped in, capitalised the banks, wiped out the banks’ bondholders and shareholders (ensuring that the losses would not fall on the fund itself) and restored, in association with the Central Bank, the banking system. In each of these occasions, the ex post market valuation of the banking system exceeded the ex ante capital injected by the public fund into it. There is no reason why the ESM could not do likewise. Even if there are net losses in the case of some banks, the net gains made from the rest of the ESM’s banking ‘portfolio’ should compensate adequately.

(Addendum: The ESM is most certainly going to take losses under the current regime anyway! The Greek state, for example, will never be able to meet its current repayment schedule, for the 40 to 50 billion we borrowed for the banks. The rescheduling of Greece’s repayments that Mrs Merkel and Dr Schaeuble have promised Prime Minister Samaras is a haircut, at least in present value terms.)

If the ESM’s bank recapitalisations could return a profit, why wouldn’t any private investor be willing to do it?

Three reasons: First, to succeed, this type of recapitalisation must come with economies of scale and substantial coordination that private investors cannot pull off. (Recapitalising one bank in an environment where many are zombiefied, does not generate the trust and optimism throughout the banking sector that would make this investment safe). Secondly, at a time of a general banking malaise, no private investor can (or wants to) raise the capital required (recall also Keynes’ characterisation of investors as “fair weather sailors who not only abandon their vessels in a storm but also destroy the lifeboats that can transport to dry land”). Third, TARP, the ESM etc. can/do work together with legislators and the Central Bank to make this happen. Private investors cannot do this.

Public Debt Crisis (Policy 2)

Turning now to the proposal that the ECB offers member-states the opportunity for a limited debt conversion (Policy 2), pertaining only to their Maastricht compliant debt (and thus limited), what happens to the remaining debt (exceeding the Maastricht limits of 60% of GDP)?

It is simple: The ‘bad’ or ‘red’ or Maastricht non-compliant’ part of maturing bonds will have to be repaid by the member-states – as is the case now for 100% of their debt. There are two possibilities here for over-indebted member-states:

One is that they will have to pay high interest rates for that part of newly issued debt (compared to the ultra low interest of the ‘good’ or ‘blue’ part that the ECB’s scheme makes possible). This is a major strength of our proposal, rather than a weakness, in that it addresses the (mostly German) fears of ‘moral hazard’, and giving governments a powerful incentive to stick within the Maastricht limits. It answers Mr Schaeuble’s concern that ECB action should not encourage member-states to allow their debt-to-GDP ratio to run riot.

A second possibility is that a member-state will not be able to repay its ‘bad’ or ‘red’ debt in full, in which case that part will have to be restructured using the CACs already included in all post Greek PSI bond issues. This is as it should be. Investors (banks in particular) should know that, if they lend to a heavily indebted member-state, the ‘red’ or ‘bad’ part of that sum might be ‘haircut’. Such discipline amongst investors would be a godsend and put an end to the preposterous presumption of assuming that a bankrupted member-state will invariably meet its obligations in full, come what may, by borrowing from the rest of Europe on the (absurd) condition of shrinking its national income (i.e. harsh austerity).

Your proposal includes giving super seniority status to the member-states obligations to the ECB for the servicing of the ECB-bonds issued on behalf of that member-state. But super seniority status has to have various attributes in order to have any substance. The first and foremost attribute is that it is paid BEFORE any other debt.

Quite right. This is the meaning of super-seniority, and it is what gives the Modest Proposal’s second policy, i.e. the proposed ECB-mediated public debt conversion facility, its credibility.

But does this not mean that the debt over and above the Maastricht compliant component (or the ‘red’ debt), which is to be refinanced by the member state itself, must mature after the ECB-mediated debt is repaid?

It is not a question of timing. It is a question of ranking debt obligations. The member-state’s agreement with the ECB should say, explicitly, that when a payment is due into its ECB debit account (in order to redeem an ECB-bond issued in the past on behalf of that member-state), it takes priority over all other debt repayments of the said member-state. Nothing different to the agreement each of our states has with the IMF.

Surely this will affect dramatically the interest to be paid on the ‘red’, non-Maastricht compliant, debt!

As it should! Remember: A large interest rate differential between the ‘good’ and the ‘bad’ (or the ‘blue’ and ‘red’) debts of our member-states is an essential part of our policy’s design, which we think makes it both (a) potentially appealing to fiscal ‘hawks’ and (b) an appropriate signal to governments and investors.

Still, I fail to see how the ECB-bonds will be sold at a low interest rate, if the repayment risk stays with the member-state without any form of guarantee by the ECB.

There is a misunderstanding here: The ECB-bonds will be issued and backed fully by the ECB. From the perspective of investors, they will be dealing only with the ECB, which will guarantee to them that they will get their money back, with interest. This is why the interest rate of these ECB-bonds will be tiny. Then, it is a matter for the ECB to recover these monies from the member-states. To ensure an almost 100% probability of full recovery, Policy 2 of the Modest Proposal includes not only the super-seniority clause (discussed above) but, also (and quite importantly), the provisions that:

  • the ECB charges a small fee to all member-states for this ‘service’ (e.g. 20 basis points), and
  • the ESM use a small part of its funding to buy additional insurance for the ECB, in case of an ultra-hard default by some member-state (thus, the ESM acts like an official CDS provider for the ECB)

Under these provisions, the ECB will be able to borrow (in today’s conditions) at no more than 1.1% and charge member-states, say, an ultra low 1.3% for servicing their ‘good’/blue’ debt. Overall, that would reduce the present value of aggregate Eurozone debt by at least 30%, bringing down with it the interest rates for the ‘bad’/’red’ debt (while preserving the large spread between the ‘good’ and ‘bad’ debts). In effect, the Eurozone’s debt crisis goes away!

Don’t’ you think that the 60% of GDP threshold, for the ‘blue’/’’red’ distinction, is arbitrary.

Of course it is arbitrary. But it is in the Maastricht Treaty and our Modest Proposal is about finding a solution within the existing (arbitrary and, in my view, idiotic) Treaties.

The Maastricht Treaty sets other economic targets that are interrelated, such as the Deficit-to-GDP ratio. In reality if the latter is higher or lower it will affect the perspective of the Debt-to-GDP ratio. In 2009 Greece, for example, had a Deficit-to-GDP ratio over 15%. No level of debt would have been acceptable (at least in the near term) under the circumstances.

Agreed. Your point about Greece, but also Ireland, proves that the Maastricht limits were meaningless, as no deficit member-state could be prevented from falling into a black hole after various bubbles burst (a public debt bubble in the case of Greece, a real estate and banking bubble in Ireland’s case). That we should have more flexible, and rational (i.e. less arbitrary), limits/rules is, of course, correct. That we should have had mechanisms from limiting the capital flow and current account imbalances prior to the crisis, is also correct. But the Modest Proposal takes these Treaties and the various mechanisms and rules in place as given, at least for now – until the current crisis is overcome. And here is another strength of the Modest Proposal: By ‘Europeanising’ (a) bank recaps (Policy 1), (b) the ‘blue’/’good’ debt (Policy 2) and (c) public investment (Policy 3), it makes it easier for governments (like Greece’s) to stay within the Maastricht limits, re. the budget deficit, in difficult times. Once the Eurozone is re-balanced, by the implementation of Policies 1,2&3, even Berlin will be more open to a serious discussion about overhauling Maastricht’s arbitrary rules.

Investment-Led Recovery Program (Policy 3)

Again here I fail to see how there will be a massive investment program (which I am in favour of) without this being supported by the other member states, hence violating the Modest Proposal’s commitment to finding solutions within the existing ‘rule’s and Treaties.

This is important. So, let’s look at this carefully.

The EIB and EIF are two profit making organizations. Why would they go along with your proposal?

The EIB-EIF operate on banking principles, and that is a good thing. But, there are not private profit-maximising banks, which is crucial. They are public institutions whose charter specifies that they exist to assist with the EU’s broader economic objectives. Rather than maximising profit, they operate on a basis of minimum profit targets (as most organisations, private ones too, do).

If the EIB/EIF are today willing to invest in any project, there is nothing precluding them to do so.

Alas there is: it is the convention that 50% of a project must be co-financed by the member-state. The fact that member-states are either insolvent (e.g. Greece) or illiquid (e.g. Austria) erects a huge constraint upon the EIB’s plans, say, to fund a super-fast railway linking Patra to Munich, via Vienna. The Modest Proposal’s Policy 3 suggests that the EIB is unshackled from this constraint and that the ECB comes to its assistance in order to bring into fruition projects that the EIB considers potentially profitable but cannot rely on Greek or Austrian (temporarily cash-strapped) partners.

We have, in fact, suggested two ways in which the ECB can offer the backing necessary.

One is through a form of non-toxic Quantitative Easing: Once the EIB approves some major project (on sound banking principles, at a time when the member-states that will benefit are illiquid), it issues EIB-bonds to cover 100% of the funding and the ECB stands by so that, if EIB-bond yields begin to rise (because the EIB is borrowing in its own name a lot more from the markets than in the past), the ECB steps in and purchases these bonds in the secondary market in quantities necessary to bring the yields down. In a deflationary Europe, where Mr Draghi is struggling to find ways of introducing some form of QE (but has no Eurobond to purchase, unlike the Fed that buys US Treasuries of the Bank of England that buys gilts), buying EIB bonds is the obvious thing to do. Moreover, unlike US or UK style QE, which inflates bubbles in the financial sector (when CDOs, mortgages, credit card debt and the like are purchased with Central Bank money), buying EIB bonds avoids this pitfall and allows the ECB to be more surgical and efficient in its anti-deflation intervention, partnering up with the EIB for this purpose.

A second method is the following: Once the EIB approves some major project, it issues EIB-bonds to cover 50% of the funding, as it currently does, but the ECB issues additional ECB-bonds (since, Policy 2 will have created the mechanism for such issues anyway) to cover the remaining 50%, which it then charges to the debit accounts of the member-states that will benefit directly from the EIB-funded project. Then, it is the member-state that takes on that risk (as now) but does this at very low interest rates that only the ECB can secure on its behalf.

These two methods Could, In Fact, Be Combined To Create An Investment Injection Into The Eurozone Of 8% Of Overall Gdp. Such An ‘Injection’ Would Then ‘Crowd In’ Private Investment That Will Blow New Wind Into The Eib’s Sails And Ward Off The Recession/Deflation/Depression Afflicting The Eurozone. Put Slightly Differently, It Is Erroneous To Think Of The Eib’s Expected Returns From Some Project As Exogenous To Eib Policies And Impervious To A Broad, Investment-Led Recovery Program Like The One Policy 3 Of The Modest Proposal Recommends.


Humanitarian CRISIS (Policy 4)

There are probably many sources, besides TARGET2, from where funds can be raised for Policy 4. Even direct financing from member states.

Of course there are. But, once again, the Modest Proposal is making recommendations that require no Treaty changes. Which means we sought funds that would not require fiscal transfers or “direct financing from member-states”. The beauty of tapping into TARGET2 accumulated interest is that these monies are not the result of fiscal transfers but merely accounting profits whose volume reflects nothing but the internal imbalances of the Eurozone – which are also responsible for the hardship of millions of Europeans.

I can only agree with such a policy assuming its implementation is less costly than the benefits to be distributed (and that it does not produce counter incentives to receivers).

Our suggestion is that these TARGET2 funds pay for a US food stamp type of program – an utterly low cost, superbly efficient system for countering hunger and fighting poverty (the evidence from the US is overwhelming) and, indeed, for propping up food producers, super-markets etc. As for your fear of “counter-incentives to receivers”, when the hungry get fed no incentives are distorted. Even if some less hungry people are fed, in this manner, that is fine too…

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About Lambert Strether

Readers, I have had a correspondent characterize my views as realistic cynical. Let me briefly explain them. I believe in universal programs that provide concrete material benefits, especially to the working class. Medicare for All is the prime example, but tuition-free college and a Post Office Bank also fall under this heading. So do a Jobs Guarantee and a Debt Jubilee. Clearly, neither liberal Democrats nor conservative Republicans can deliver on such programs, because the two are different flavors of neoliberalism (“Because markets”). I don’t much care about the “ism” that delivers the benefits, although whichever one does have to put common humanity first, as opposed to markets. Could be a second FDR saving capitalism, democratic socialism leashing and collaring it, or communism razing it. I don’t much care, as long as the benefits are delivered. To me, the key issue — and this is why Medicare for All is always first with me — is the tens of thousands of excess “deaths from despair,” as described by the Case-Deaton study, and other recent studies. That enormous body count makes Medicare for All, at the very least, a moral and strategic imperative. And that level of suffering and organic damage makes the concerns of identity politics — even the worthy fight to help the refugees Bush, Obama, and Clinton’s wars created — bright shiny objects by comparison. Hence my frustration with the news flow — currently in my view the swirling intersection of two, separate Shock Doctrine campaigns, one by the Administration, and the other by out-of-power liberals and their allies in the State and in the press — a news flow that constantly forces me to focus on matters that I regard as of secondary importance to the excess deaths. What kind of political economy is it that halts or even reverses the increases in life expectancy that civilized societies have achieved? I am also very hopeful that the continuing destruction of both party establishments will open the space for voices supporting programs similar to those I have listed; let’s call such voices “the left.” Volatility creates opportunity, especially if the Democrat establishment, which puts markets first and opposes all such programs, isn’t allowed to get back into the saddle. Eyes on the prize! I love the tactical level, and secretly love even the horse race, since I’ve been blogging about it daily for fourteen years, but everything I write has this perspective at the back of it.

8 comments

  1. The Dork of Cork

    I have a very very modest solution.
    Give purchasing power back to the people of each nation.
    This involves the non production of credit , the allocation of a basic income to each person and the tearing up of debt contracts.
    Deflation then becomes a good thing.
    Problem solved as currently there is more then enough stuff.

    In my opinion Yanis Varoufakis is a classic bank lobbyist – his modest proposal is anything but.

    1. jgordon

      Yanis Varoufakis is hewing to the standard theory that growing economies require an expandable currency. Even as “unorthodox” as Yanis is, he’s still unwilling to grapple with the fact that expanding the real economy (as opposed to nominal gimmickry) is simply not going to happen whichever fancy theories are applied–well because we’ve reached peak resource extraction. So while the population yet expands, there will be a smaller slice of the industrial pie for everyone. And then this is exacerbated by the known fact that elites in failing societies try to grab everything they can as they prepare their bolthole for the inevitable collapse.

      Well anyway that’s my long winded way of saying that Yanis should acknowledge that the industrial experiment is just about over with and devote his many talents to studying ways to live better in the aftermath rather than submitting fanciful and elaborate propositions to an elite crowd that’s already doing its best to strip the walls bare while eyeing the exit doors.

  2. John

    Banking crises — nothing is fixed and nothing will be and we should come to realize this. Politicians are in bed with bankers. BES proves the point. Our friends used taxpayer money to bail them out. Banks are more like ‘zombies’ which refuse to lend. They recklessly lent to the periphery countries and bought into the sub-prime mortgages which blew up in their faces so lending is a bad word.

    Investment led recovery program — lets keep it simple (KISS). There are loud calls for Germany to boost wages. Thats an excellent place to start. Once Germans start buying because of their new found cash, the German government should start on massive infrastructure projects. They must lose the export model fantasy to prosperity. Bad banks should be sent into bankruptcy.

    We need Germany to pull us out of the stagnant rut we are in. If we focus on other marginal institutions for help, like the ECB or ESM or some other bureaucratic apparatus, the goal posts simply don’t budge.

    1. James Levy

      What they won’t admit is that they lent to the peripheral countries to create demand to stimulate their own national economies (Germany being the biggest beneficiary of this policy). This is a demonstrable fact, but that “narrative” is verboten (it is sick that we now live in a world where narratives trump reality, but there we are). Again, for the millionth time we see the idiotic behavior of creating demand through debt rather than wages (because real men collect rent while losers run around trying to sell things for a profit). We have an inversion of the term “risk”–commodity production for the market is now viewed as risky, but collecting interest, dividends, and rents, no matter how shaky the instruments generating those interest, dividend, and rent payments, is considered safe. This is the result of propping up the value of assets at the expense of everything else. They bet the farm on making the stock, bond, and derivative holders whole, and they’ve created a monster in the process.

  3. The Dork of Cork

    @John
    “We need Germany ??????????”

    “There are loud calls for Germany to boost wages”
    Wages in the current structure increase costs………if the goods produced become unaffordable ?????

    Watch the ding dong between these clowns on the Irish economy blog to understand the structure of the modern irish economy.
    Its quite eduacational but in a inverse fashion.

    John the Optimist (GDP fettish) vs Michael Hennigan (export and competitiveness fettish)
    http://www.irisheconomy.ie/index.php/2014/09/21/lessons-from-ireland/#comment-1247255

    “The National Competitiveness Council, a public quango, would be much more muted with claims on competitiveness claims.

    If you believe this: [Unit labour costs: “a 21% relative improvement forecast against the Eurozone average”] Prof Patrick Honohan would include among “superficial analysts.”

    The average hourly labour cost covering all sectors of the economy other than ‘Agriculture, forestry and fishing’ was €25.03 in the first quarter (Q1) of 2008 and €24.89 in Q2 2014 and there was no relative productivity miracle.

    “Ireland was the only country in the EU to experience a decrease in inflation between 2008 and 2012 but prices remain high by EU standards” – – CSO, Jan 2014

    In 2013 Irish prices for consumer goods and services were 18% above the European Union (EU) average and fifth highest in the EU28 – – Eurostat, June 2014″

    Dork :
    In the current structure of extremely concentrated capital ownership the only way the average or median person can increase their purchasing power is via increased wages.
    However this also increases prices of goods and services and if these goods and services become unaffordable well…………anybody can figure it out really.
    The production distribution and consumption system breaks down.
    In the past this absurdity was overcome via pointless economic expansion.
    Under the state capitalism of Ireland for example the state helped corporates to export surplus beef to Iraq or something via various state guarantees.
    But this GDP /export expansion can no longer continue in Ireland without the enforced starvation of millions (think of Ireland between the 1820s banking crisis and 1840s famine stage )

    The social credit position would indeed advocate a reduction of wages (say 25%) but would also give each person a equal share of the countries capital
    Problem solved.
    The type of goods produced would radically change of course.
    21% ~ of Irish oil consumption is currently jet kerosene alone.
    That would end pronto.
    Ryanair and other corporates dependent on fuel waste would find themselves out of businesss as the back and forth nature of the current Brownian motion economy would be no more.
    Who would work for a corporate which uses labour as a livestock anyhow.
    People would have a choice as they would already have access to purchasing power without labour.
    Therefore no need for corrupt unions either
    All of these non problems (created by the corporate state) would be solved very quickly

  4. Jackrabbit

    My original response to this ‘Modest Proposal’ was simply that it could work – for a time. But it seems to me that this establishment friendly response is extremely insufficient. I don’t think it addresses the fundamental social and economic problems. Instead it papers over and exacerbates them.

    In the US, QE has been a boon for the wealthy who have seen paper profits. Their 2008 discontent evaporated. Whew! Imagine if a large group of wealthy/well-off people actually got angry?! Can’t have THAT. Then there is government assistance/food stamp program. If such a ‘safety net’ didn’t exist there would be riots. But the prevalence of part-time, low wage jobs and foodstamps are not helping the economy, and therefore not leading to opportunities to move up to good jobs. They ‘safety net’ has become a pay-off: reducing discontent enough to allow an oligarch-friendly government a free hand.

    So there is a mismatch here. The well-off seek paper returns on their capital of x% to be satisfied; the poor need a stipend of $x to make ends meet. But satisfying the minimum requirements of each is only delaying the inevitable because those returns can’t be justified by a stagnant economy and warehousing the poor in a stagnant economy is only guarantying that they remain poor and dependent on government subsidies.

    Doesn’t this establish a race to financial panic? And the ‘winners’ of this race are the elites that have asymmetric information and can grab as much as they can before that happens (mostly at the expense of the middle class). In this context, Summers and Krugman plead for financial bubbles because the steps taken to rescue TBTF banks and restore confidence in our political economy have only kicked the can. But this perverse, ‘last ditch’ TINA! stimulus really only masks what is happening to the economy. QE and Government’s ‘safety net’ can be used to immunize the real economy from these financial panics (as in 2008), but the trajectory of the economy is still down with sugar highs along the way.

    If ordinary people had a real voice in government, the short-term thinking that leads to such ‘gaming’ and decay would be much less likely. And I would be remiss not to mention the irresponsible response to climate change as another symptom (among many others) of the ‘best government money can buy’.

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    H O P

    1. Jackrabbit

      I wrote: “QE and Government’s ‘safety net’ can be used to immunize the real economy from these financial panics (as in 2008)” . . . Actually any ‘immunization’ is only partial. And to a great degree that is due to the ‘blame the victim’ political environment, where any setback requires that government tighten its belt (austerity) and thereby not spend what would be required to provide fiscal stimulus, retraining, etc. The fact is, the unemployed don’t contribute much to political campaigns.

      Also: those shills who advocate for bubbles talk as though bubbles are something of a free lunch. We can manage through any down turn, they say, like we did in 2008 . . . plus, TINA. But bubbles cause malinvestment. That is a REAL cost. The only ones that really benefit are market insiders – especially with tax advantages like the carried interest tax deduction.

  5. docg

    I disagree that ISIS has “plundered Mao’s playbook.” Mao’s tactics were those of classic guerrilla warfare: you hit hard with a superior force and then vanish into the woodwork. You avoid pitched battles with organized armies. You become close to the people in the area where you’re based, gaining their confidence and recruiting among them.

    ISIS may have begun with such tactics, but recently they have abandoned them and have begun fighting in a more traditional manner, taking territory in pitched battles and then attempting to hold it by setting up conventional defense perimeters. Brimming with overconfidence, they see themselves, literally, as a “state,” or in their terms a “Caliphate,” an absurd designation which, ironically, they may have picked up from some of Glenn Beck’s more paranoid rants. Moreover, they have gone out of their way to intimidate and even terrorize the people in the regions they have conquered, a tactic that will eventually backfire, as increased resentment leads to subversion. Their supposed strength will ultimately become their weakness: in attempting to hold vast areas of the conquered territory they have stretched themselves thin and are now vulnerable to counter-attacks, which could come at any point along their weakly defended borders.

    Their decision to present themselves as a state, rather than a revolutionary movement, and fight conventional battles in the old, 20th century manner, is a huge mistake, as they won’t be strong enough to take on a modern army. Moreover, his is not Afghanistan, where the Taliban can hide in the hills and in caves. This is desert country, where visibility from the air is unimpeded. Sure, they can mingle with civilians in the cities, but if they want to launch the sort of attacks needed in order to take over a country, they will need to come out in the open, and they will also need supply lines that will of necessity travel over desert terrain. This makes them highly vulnerable to air and artillery attack. Remember what happened to Saddam’s army when he attacked Kuwait. It’s true they’ve picked up lots of powerful US equipment, which makes them dangerous for the time being. But soon they will be needing spare parts, which won’t be so easy to find.

    I give them 6 months, tops.

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