Are the Ratings Agencies Abandoning Fiscal Austerity?

Despite downgrades, even ratings agencies may be figuring out the economies in peril can't be helped by mindless cuts and contractions.

So the ratings agencies have finally followed through on the big threat and downgraded a number of the eurozone’s credit ratings, including France and Austria, both of which have now lost their coveted Triple AAA status. Italy, Portugal and Spain were downgraded a further two notches.

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What does this mean and why does it matter?

Investors (often badly informed) use ratings agencies like Fitch, Moody’s and S&P as an indicator of default risk of a country. Countries that receive lower credit ratings are at a disadvantage when they sell bonds because buyers will not pay as much for bonds from a country perceived to be at risk. In effect, ratings agencies are able to bully countries into adopting policies that are friendly to the ratings agencies’ investors. A compliant government often reacts like Pavlov’s dog to the threat or implementation of a downgrade, putting aside the interests of its citizens and starting to introduce discretionary contractions in its net spending, which it does by either raising taxes or cutting spending.

The Eurozone’s Financial House of Cards

My take is that the ratings downgrade causes a vicious cycle in which countries will end up adopting policies that will put their economies even more at risk than they were already. The reason for this is that in Europe, you’ve got a flawed financial structure that can’t be fixed by austerity measures because it is incapable of dealing with huge external shocks to the demand for goods and services on the part of consumers.

Eurozone countries have faced two types of problems by entering the euro regime that have made them unstable.

First, they have given up their monetary sovereignty by giving up their national currencies and adopting a supranational one. By divorcing the fiscal authority (that which governs a country’s public treasury) from the monetary authority (that which governs the supply of money) member countries have relinquished their public sector’s capacity to provide high levels of employment and output because they are restricted in what they can spend and how they can introduce stimulation in the form of jobs programs or infrastructure projects.

Second, by entering the eurozone, these countries have also agreed to abide by something called the Maastricht Treaty, an agreement which created the European Union and led to the creation of the euro in 1992. This treaty restricts each member country’s budget deficit to only 3 % and debt to 60% of GDP. Therefore, even if a country is able to borrow and finance its deficit spending, like Germany and France, it is not supposed to use fiscal policy above those limits. So countries have resorted to different means to keep their national economies afloat, from trying to foster the export sector, as Germany does, to cooking the books through Wall Street wizardry, like Greece and Italy did. Nations that exceed the limits by the greatest amounts are punished with high interest rates that drive them into a vicious death spiral because deficits rise and lead to further credit downgrades. That is what has happened to Greece, Ireland, Portugal, etc., and now threatens Italy and Spain. Vultures will soon be looking further into the core to places like France.

By contrast, a sovereign government which issued its own currency (such as the US or Canada) could respond to a huge drop in economic activity by expanding fiscal stimulus, or allowing the currency to fall (thereby enhancing growth through exports). On the other hand, eurozone governments ceded their national currencies to the European Central Bank (ECB), the sole entity that can issue unlimited amounts of euros. That is why we’re left with a situation in which the solvency crisis can only be solved by the ECB: It is the only entity which is in a position to buy unlimited quantities of national sovereign bonds in order to ensure that these countries do not continue to pay ruinous rates of interest and suffer further declines in economic activity as a consequence. Fiscal austerity only adds to the problem.

Deficits are the Symptom, Not the Cause of Slow Growth

Instead of understanding the true nature of the problem, however, European leaders will likely yet again focus on the fake problem of "runaway government spending" and fail to see that the rising deficits are a symptom of slower economic growth, and not the cause. Blaming slow growth on deficits is kind of like blaming the thermometer for recording a temperature when the patient has the flu. Sadly, if the current trajectory of austerity policies continues, you'll get evenslower economic growth, lower tax revenues, and higher social welfare expenditures, which will expand the deficits even further. This will happen all throughout Europe.

So far, countries like Greece and Spain have been the hardest hit by the eurozone crisis. But even Germany is starting to feel the harmful effects of austerity politics. Despite relatively low unemployment, Germany has recorded a negative quarter of growth in Q4, with worse expected in the coming months. The lagged effect of declining economy activity in the eurozone’s periphery, which a big source of German exports, is starting to impact on the core countries, such as Germany and France. Germany can make all the cars it wants, but eventually, if its neighbors can’t afford to buy them because austerity measures have made them poorer, then it, too, will suffer. Yet the euro elites continue to offer the economic equivalent of more mediaeval style blood-letting, even as the patient continues to hemorrhage further, economically speaking.

Solving the Real Crisis

Ironically, even the dreaded ratings agencies are beginning to recognize that the eurozone’s national solvency crisis cannot simply be solved through further simpleminded cuts in government spending. So what are they proposing? Well, Fitch, a rival of Standard & Poor, is now suggesting that the ECB “ramp up its buying of troubled euro zone debt to support Italy and prevent a ‘cataclysmic’ collapse of the euro.” Fitch argues that a collapse of the euro would be “disastrous to the global economy” and urged the ECB “to abandon its current reluctance to scaling up its purchases of troubled euro zone debt … and drop its resistance to the bloc’s bailout fund, the EFSF, borrowing directly from it.”

In other words, the ratings agencies are recommending stimulative measures on the part of Europe’s Central Bank – just what the austerity hawks advise against!

Despite the flawed design of the eurozone’s financial house, the ECB could improve the situation by dealing the financial markets out of the game immediately. All that would be required would be for the ECB to announce – explicitly – that it was prepared to buy all government debt at a stated interest rate. If it did that, the so-called “financial” crisis would evaporate.

The real crisis would take longer to solve because employment has to rise and the private sector has to repair its credit-binged balance sheet through saving. This would require on-going and fairly substantial net public spending support for at least the next 10 years – exactly the opposite to the direction imposed by the European Commission and the Troika (the three-part decision-making body which consists of the European Union, the International Monetary Fund, and the European Central Bank).

And what about inflation? That’s a main fear of the folks who call for austerity measures as opposed to stimulative policies. Interestingly, Fitch also said that the ECB “had plenty of scope to expand its balance sheet without unleashing a wave of inflation across the Eurozone.” In fact, there is no sign that the ECB's buying of euro denominated government bonds has resulted in any kind of inflation thus far. For inflation to take hold, you need expanded spending. However, in this case, the ECB’s bond buying operations come only with reduced spending through its imposition of fiscal austerity as the quid pro quo for buying the bonds. And reduced spending reduces consumer demand for goods and services.

When the ECB is buying bonds in the secondary market, the bond holder who sells the bonds receives the proceeds of the bond sale, which then sit as a deposit in the central bank in the form of reserves. And, as JJ Lando from Nomura Securities has noted:

“Commercial banks and people do NOT have the capacity to destroy those reserves. Once the Fed or ECB wires the money or creates that asset line item on its spreadsheet, there is an equal and offsetting liability on its spreadsheet called reserves. This spreadsheet cannot be broken. All that commercial banks can do is lending, which moves some of those reserves from ‘excess’ to ‘required’ but they are still there. Commercial Banks make this lending decision based upon regulatory capital and profit motives, not based upon reserves. They have a ‘captive audience’ in their Central Banks, who MUST create the necessary reserves (a floored amount) to prevent interest rates from going to infinity.”

Some might argue that the ECB's balance sheet would be impaired by buying up the government debt of countries in distress. But this is not true, because by definition, the “profligates” cannot default. In fact, as the monopoly provider of the euro, the ECB could easily set the rate at which it buys the bonds (say, 4% for Italy) and eventually it would receive a profit on those loans.

It is also important to note that the ECB wouldn’t be doing this forever. The markets would eventually come to do the ECB’s heavy lifting for them: Convinced that the ECB was serious about resolving the solvency issue, the markets would begin to buy the bonds again. The bonds would not be trading at these distressed levels if not for the solvency issue, which the ECB can easily address if it chooses to do so. But this is a question of political will.

What I’ve proposed might seem politically impossible for the ECB. But democracies don’t “do” deflation very well. Contrary to conventional wisdsom, it’s the eurozone’s currently ruinous fiscal austerity policies that are truly politically unsustainable. They will not only cause more economic and social misery, but they undermine much of the residual political support for the common currency. Consider the case of Austria, which lost its AAA rating along with France. The leader of Austria’s far right FPÖ, H.C. Strache, has embraced an explicitly anti-euro position, and he is gaining political traction in the polls, as is Marine Le Pen, leader of the National Front in France, where Presidential elections are due to be held in 3 months’ time.. Both oppose the euro — to be fair — for the right reasons. The only problem is that the rest of their policies are a dystopian nightmare. Similarly, in an interview with German daily Die Welt (and the choice and location of publication is extremely important), the new head of Italy’s “technocratic” government, Mario Monti, lamented that despite Italy’s considerable fiscal austerity measures, they aren’t seeing lower interest rates. Fiscal austerity in the midst of a recession is bad policy at the best of times, but Monti did what he was told and now he’s got nothing to show for it. Has he become the victim of a German “Italian Job” (all you Michael Caine fans will know what I’m talking about here).

Monti has pointed to the threat that Italian sentiment is finely balanced. Make the wrong decision now, he said, and the populists will take control. With that in mind, observe that the Italian Social Democrat party commented last week that it would like to see Italy leave EMU.

Are we about to reenact the 1930s? Will Mario Draghi, Angela Merkel and Nicolas Sarkozy, the current champions of fiscal austerity in the eurozone, pay attention to the ground cracking beneath their feet?



Marshall Auerback is a market analyst and commentator.