By Ha-Joon Chang
Even the most rational Europeans must now feel that Friday the 13th is an unlucky day after all. On that day last week, the Greek debt restructuring negotiation broke down, with many bondholders refusing to join the voluntary 50% "haircut" – that is, debt write-off – scheme, agreed last summer. While the negotiation may resume, this has dramatically increased the chance of disorderly Greek default.
Later in the day, Standard & Poor's, one of the big three credit ratings agencies, downgraded nine of the 17 eurozone economies. As a result, Portugal pulled off the hat-trick of getting a "junk" rating by all of the big three, while France was deprived of its coveted AAA rating. With Germany left as the only AAA-rated large economy backing the eurozone rescue fund (the Dutch economy, the second biggest AAA economy left, is much smaller than the French economy) the eurozone crisis looks that much more difficult to handle.
The eurozone countries criticise S&P, and other ratings agencies, for unjustly downgrading their economies. France is particularly upset that it was downgraded while Britain has kept its AAA status, hinting at an Anglo-American conspiracy against France. But this does not wash, as one of the big three, Fitch, is 80% owned by a French company.
Nevertheless, France has some grounds to be aggrieved, as it is doing better on many economic indicators, including budget deficit, than Britain. And given the incompetence and cynicism of the big three exposed by the 1997 Asian financial crisis and more dramatically by the 2008 global financial crisis, there are good grounds for doubting their judgments.
However, the eurozone countries need to realise that its Friday-the-13th misfortune was in no small part their own doing.
First of all, the downgrading owes a lot to the austerity-driven downward adjustments that the core eurozone countries, especially Germany, have imposed upon the periphery economies. As the ratings agencies themselves have often – albeit inconsistently – pointed out, austerity reduces economic growth, which then diminishes the growth of tax revenue, making the budget deficit problem more intractable. The resulting financial turmoil drags even the healthier economies down, which is what we have just seen.
Even the breakdown in the Greek debt negotiation is partly due to past eurozone policy action. In the euro crisis talks last autumn, France took the lead in shooting down the German proposal that the holders of sovereign debts be forced to accept haircuts in a crisis. Having thus delegitimised the very idea of compulsory debt restructuring, the eurozone countries should not be surprised that many holders of Greek government papers are refusing to join a voluntary one.
On top of that, the eurozone countries need to understand why the ratings agencies keep returning to haunt them. Last autumn's EU proposal to strengthen regulation on the ratings industry shows that the eurozone policymakers think the main problem with the ratings industry is lack of competition and transparency. However, the undue influence of the agencies owes a lot more to the very nature of the financial system that the European (and other) policymakers have let evolve in the last couple of decades.
First, over this period they have installed a financial regulatory structure that is highly dependent on the credit ratings agencies. So we measure the capital bases of financial institutions, which determine their abilities to lend, by weighting the assets they own by their respective credit ratings. We also demand that certain financial institutions (eg pension funds, insurance companies) cannot own assets with below a certain minimum credit rating. All well intentioned, but it is no big surprise that such regulatory structure makes the ratings agencies highly influential.
The Americans have actually cottoned on this problem and made the regulatory system less dependent on credit ratings in the Dodd-Frank Act, but the European regulators have failed to do the same. It is no good complaining that ratings agencies are too powerful while keeping in place all those regulations that make them so.
Most fundamentally, and this is what the Americans as well as the Europeans fail to see, the increasingly long-distance and complex nature of our financial system has increased our dependence on ratings agencies.
In the old days, few bothered to engage a credit ratings agency because they dealt with what they knew. Banks lent to companies that they knew or to local households, whose behaviours they could easily understand, even if they did not know them individually. Most people bought financial products from companies and governments of their own countries in their own currencies. However, with greater deregulation of finance, people are increasingly buying and selling financial products issued by companies and countries that they do not really understand. To make it worse, those products are often complex, composite ones created through financial engineering. As a result, we have become increasingly dependent on someone else – that is, the ratings agencies – to tell us how risky our financial actions are.
This means that, unless we simplify the system and structurally reduce the need for the ratings agencies, our dependence on them will persist – if somewhat reduced – even if we make financial regulation less dependent on credit ratings.
The eurozone, and more broadly Europe, is slowly strangling itself with a toxic mixture of austerity and a structurally flawed financial system. Without a radical rethink on the issues of budget deficit, sovereign bankruptcy and financial reform, the continent is doomed to a prolonged period of turmoil and stagnation.
