Europe’s Downgrades: Message to America?

Europe’s Downgrades: Message to America?
January 18, 2012

Steve Stanek

Steve Stanek (sstanek@heartland.org) is a research fellow at The Heartland Institute and managing... (read full bio)

With Standard & Poor’s having downgraded the government debt ratings of nine European nations in mid-January, some experts are saying there’s also a message for this nation’s federal, state, and local governments.

“It is clear that the debt downgrades are sending messages to both European and U.S. governments. The short-term and long-term message is the same: Get debt and deficits under control, or massive problems—bankruptcy, currency chaos, etc.—will ensue,” said Robert B. Ekelund Jr., eminent scholar and professor of economics emeritus at Auburn University. “Basically, I think the rating agencies are telling these governments, including our own, that they are not being speedy enough at this task.”

Ekelund said it’s clear some European governments, notably in Germany, “are giving austerity a push,” but governments in Greece, Italy, and some other fiscally challenged countries are pushing back against austerity.

Could Be Worse

If anything, said Ekelund, it’s possible the debt situations are worse than the S&P downgrades indicate.

“We should remember that ratings agencies gave junk securities high ratings in the United States just before the financial crash,” Ekelund said. “Do we now trust them with calculating and rating the magnitude of economy-wide problems, which obviously do exist?”

"Today's rating actions are primarily driven by our assessment that the policy initiatives that have been taken by European policy makers in recent weeks may be insufficient to fully address ongoing systemic stresses in the euro zone," S&P said in a January 13 press statement announcing the downgrade.

Cyprus, Italy, Portugal, and Spain saw their debt ratings drop two notches. S&P cut its ratings on Austria, France, Malta, Slovakia, and Slovenia by one notch.

Italy now has a BBB+ rating, on par with Kazakhstan. Portugal’s debt is now rated junk.

S&P affirmed its ratings on the government debt of Belgium, Estonia, Finland, Germany, Ireland, Luxembourg, and the Netherlands.

Rates Could Rise

“Downgrades are a clear sign that real interest rates are going to rise,” said economist Mark Thornton, a senior resident fellow at the Mises Institute in Auburn, Alabama. “Rating agency grades and interest rates generally go in the opposite direction. However, the downgrades in Europe will intensify the flow of funds into the U.S. government bond market until economic conditions in Europe and elsewhere threaten the U.S. economy.

“I think the United States should view the low rates we are experiencing as the eye of the storm, i.e., a lucky temporary lull position between two crisis periods, rather than as a sign that the U.S. government is properly managing its affairs,” he said.

Unexpected Response

Perhaps paradoxically, bond yields in most euro-zone countries dropped shortly after the downgrade announcement. A similar thing happened to yields of U.S. Treasury bonds after they were downgraded by S&P last August. Ordinarily, a downgrade would be expected to result in higher yields, because bond buyers would demand lower prices, which give higher yields, to compensate for higher perceived risk.

But central banks have continued to “print” money to buy government bonds, keeping prices up and yields down. Also, S&P in December put 15 of the 17 euro-zone countries on watch for possible downgrades. So investors had anticipated S&P’s moves and had priced in the downgrades, wrote economist Stefan Karlsson in an article for The Christian Science Monitor.

Like Ekelund, Karlsson puts little reliance on the rating agencies to accurately determine the creditworthiness of government debts.

“The credit ratings of credit rating agencies shouldn't in any way be encouraged or be made a mandatory standard by governments,” Karlsson wrote. “They shouldn't play any role in legal accounting rules, nor in rules of which securities funds should invest in. This is both because it is principally wrong for governments to give private institutes such privileges and because of their awful track record (to the extent they've been ‘right’ it has almost always been because of the self-fulfilling prophecy mechanism).

“So unfortunately, the incompetent credit rating agencies matter. But they shouldn't.”

 

 

Steve Stanek

Steve Stanek (sstanek@heartland.org) is a research fellow at The Heartland Institute and managing... (read full bio)