Over the years I have always been confused about how and why credit rating agencies change their ratings. From the Washington State bonds fiasco to the derivatives securities debacle to sovereign debt downgrades, I have not been able to figure out what the agencies think that they are doing and what their role really is in this process. In recent years what has stuck out is the number of missteps agencies have made in their fundamental ratings decisions – and what damage this has done. But the timing is and has been controversial too.
With the S&P’s recent decision to downgrade nine European countries it has once again made a decision that is controversial and one that thrusts the rating agency into the vortex of euro-politics. This may not seem so at first blush. But it is clear that European nations cannot really be evaluated without knowing what Europe is going to be. And Europe has not decided what it will be just yet. Since the situation is not yet determined, members’ obligations are not yet clear. So a clear credit evaluation cannot really be made, can it? Nonetheless, S&P has made one; it has made several, in fact.
To make this a bit less abstract look at the incentives that are now in play with France, Italy and others downgraded but Germany not downgraded. There has been positioning and arguing across the Eurozone on what it should do and where it will get financing, on what will be the role of the ECB, and how to use, and leverage, the EFSF. Through it all, Germany has been refusing to cut any corners. One view of the Eurozone is for it to have more individual fiscal constraints with real enforcement, but there is also talk of some shared fiscal responsibilities. There is no decision on this just yet. It remains a work in progress.
By downgrading some key EMU counties but not downgrading Germany, S&P has driven a wedge between EMU members. It has, in fact, rewarded Germany for not undertaking any more euro-commitments at the same it has castigated the Eurozone in general and downgraded others for what amounts to the exact same thing, not making much progress.
According to S&P, the problem is that the Eurozone is not making much progress. Of course, it is not making much progress! But that is a symptom of the real problem which is lack of common vision. Until they are on the same page, they cannot make progress.
Until Europe really agrees what the Eurozone must look like, what each member's obligations will be, who will be in this Eurozone, and what sort of centralized help is available, how can S&P begin to rate anyone? On the other hand, rating Europe while all of this is in flux tends to bias the results toward an outcome that is more or less like the current arrangement, one that is highly unstable and may even be in the process of unraveling. That would mean that S&P's intercession is making things worse.
S&P seems to realize that the Eurozone depends too much on austerity. But if the Eurozone is to go beyond that, more resources will be needed and that undoubtedly would involve Germany. And if Germany were to commit more resources it almost certainly would be downgraded. So what is the message about the future in the S&P downgrades? Is the downgrade about what the countries in the Eurozone are doing now? Is it about what their behavior has been in the past? Is it about what they will become in the Eurozone of the future? How are we to understand these downgrades?
This is one of the more vexing parts of trying to analyze the role of the credit-rating agencies. At some point they and their decision become part of the process and that does not seem right. S&P seems to have acted prematurely in this case. There was no reason for it to issue new ratings when it did. Its decision not to downgrade Germany sends a clear signal to the Germans that what they are doing is ‘right,’ while what others are doing ‘is wrong.’ In doing that it makes it less likely that Germans will want to compromise on the future of the Eurozone. The Germans have championed the ‘Japanese lunch-box’ view of the zone. In this model countries are in this Zone together, but each is master of its own defined space. On paper it may look good but in practice it has not worked.
The effectiveness of the common currency and common monetary policy is undercut by the facts of the Eurozone’s performance. ECB policy has not been at fault. The ECB has been able to hit its aggregate inflation target but has done so in spite of some nations performing persistently worse than others. The persistent inflation differentials in the Eurozone and the parity differences which have steadily worsened are evidence how the ‘bento box view’ of the Eurozone simply does not work. Can country by country fiscal restraints really bridge that gap? Are the structural differences and productivity differences ultimately compatible enough for a single zone to contain the current members and to remain stable?
These are hard questions to answer. But S&P has made the answers harder by biasing the Germans toward the status quo while being very critical of the impact of the status quo on the rest of the Eurozone members!
The ratings agencies need to sort themselves out. They are supposed to be part of the solution, not part of the problem. Lately they seem to be playing the role of creating mayhem. They need a clearer statement of why and when they downgrade countries or securities. They need to find a way to make these decisions so they are not the centerpieces of the story. As things stand, the credit agencies are making markets more dangerous instead of safer and that doesn’t work for anyone.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.