Portugal’s debt has just been downgraded to junk bond status. Ireland’s efforts to boost investor confidence are under threat; Italy is starting to look wobbly.
European politicians are openly expressing their anger at the three main ratings agencies’ oligopoly, accusing them of attempting to exercise improper influence over policy-making – the timing of their downgrades is ‘not a coincidence’, and they are ‘playing politics, not economics’.
Evidence from Ireland bears this out – there seems to be no consistency in the way the ratings agencies evaluate the decisions of governments in the Eurozone periphery. Governments are put under pressure to engage in ‘orthodox’ fiscal retrenchment, in line with the EU’s excessive deficit procedures, and as required of Greece, Ireland and Portugal in line with their IMF-EU loan programmes. But as soon as they take relevant action, they find their ratings downgraded on the ‘heterodox’ grounds that taking money out of the economy will damage growth potential. Two bodies of economic theory seem to be at work here: ‘expansionary fiscal contraction’ when the aim is to enforce cuts, Keynesian counter-cyclical policy when the objective is to punish excessive contraction. Damned if you do and damned if you don’t.
Take a look at this graph, from the IMF’s May report on Ireland.
Each of the vertical red lines I’ve added represents an ‘orthodox’ fiscal adjustment on the part of the Irish government between February 2009 and December 2010. The balance was about 65% spending cuts and 35% tax increases, entirely consistent with conventional thinking. The profile looks like this:
The overall adjustment between 2008 and2014 is €29.6bn. This would be equivalent to about 19% GDP and 22% GNP in 2010. Yet Ireland’s ratings have been consistently cut.
Very odd.
{ 31 comments }
Ben 07.07.11 at 7:56 pm
A credit rating is a public expression of opinion. That is proper influence, not improper.
Investors, many of whom are giant corporations with their own analysts, are able to take a different view if they wish.
Nobody has to act on it, except… where the law says they cannot invest in anything less than AAA rated bonds! The problem is of the government’s own making therefore.
You are also conveniently ignoring the fact that there is a lot more going on than just Ireland announcing a budget, which will influence the rating. Will there be a(nother) rescue? Will the global economy pick up? Exactly which parts of the budget will they cut? What will happen to corp. tax revenues?
MPAVictoria 07.07.11 at 7:59 pm
I think it has been pretty conclusively demonstrated that the big three rating agencies have no idea what they are doing.
Chris E 07.07.11 at 8:16 pm
Ratings agencies – like any other market participant – get caught up in speculative theories of endless growth of this or that sector.
That said, this particular case is a bad one to use for bashing them. If you assume the credit rating is purely a measure of how likely lenders are to get their entire money back, then surely there is a case for downgrading Portugal – in light of events in Greece.
Ex-Lib 07.07.11 at 8:50 pm
Wasn’t all rating agency credibility burned around 2008?
Ginger Yellow 07.07.11 at 9:34 pm
There’s a third party missing in this picture: investors. A large part of the reason for, and timing of, the downgrades, has been the market pricing of the various countries’ debt. The rating agencies quite reasonably argue that when sovereign bond spreads soar, it will become more difficult to service, or even place at any price, their debt. And whenever the price of one Eurozone peripheral sovereign’s debt drops, the others follow to a greater or lesser extent. Of course, this is a vicious circle because each downgrade causes another drop in price, but the logic is hardly obscure and has nothing to do with conflicting economic theories.
mpowell 07.07.11 at 9:48 pm
Yeah, I also think you’re overreaching here. I think that the agencies suck and have no idea what they’re doing and that it’s idiotic that we use them as a regulatory substitute, but I doubt there is anything malicious going on here.
What is happening is that the Euro was an idea that was not built to last. Was it a terrible idea? I dunno. Maybe 15 years of growth was worth it. But the only way for a country to manage a recession without a debt default is to have their own currency or to have massive stockpiles of foreign currency. If the Euro governments were collectively sitting on 5T Euro they could engage in counter-fiscal policy to their heart’s content. But since they don’t, they depend on the debt markets to deal with market downturns. In some downturns, it will be literally impossible for a government to reduce the deficit below some arbitrarily chosen level. Any combination of cutting spending or raising taxes will simply depress economic output. In that case, if the debt market turns against them, the debt market creates it’s own reality: that country defaults. Look at it this way: Germany has plenty of debt/GDP. If they were paying 8% on their debt, how would they deal with it?
jfxgillis 07.07.11 at 11:46 pm
Niamh:
“Two bodies of economic theory seem to be at work here: ‘expansionary fiscal contraction’ when the aim is to enforce cuts, Keynesian counter-cyclical policy when the objective is to punish excessive contraction. Damned if you do and damned if you don’t.”
Hate to interject provincial American concerns into this cosmopolitan global thread, but that’s also almost precisely the stated policy of the Republican party. It’s at least self-interestedly rational on their part even if it’s utterly incoherent as a policy regime. What the Eurocrats think they’re going to get out of it is beyond me.
Andrew F. 07.08.11 at 1:36 am
But to state the obvious, the purpose of the ratings agencies is not to instruct a sovereign on what actions it will accept in exchange for a good rating. Cutting one’s budget in a recession will reduce demand. Maintaining high levels of borrowing when you’re unlikely to be able to service your debt in the near future will reduce the quality of your credit. Lots of factors that have nothing to do with your actions will affect your borrowing costs.
There’s nothing inconsistent about an analysis that reflects all that. In fact that’s just how someone interested purely in rating your debt – and disinterested in the resolution of your borrowing problems one way or the other – might do the analysis.
StevenAttewell 07.08.11 at 2:40 am
Establish yardstick public ratings agencies and clear out the central banks. Done.
Myles 07.08.11 at 2:48 am
<I think it has been pretty conclusively demonstrated that the big three rating agencies have no idea what they are doing.
Nonetheless, Portugal’s bonds are probably genuinely junk-grade.
Chris Abajian 07.08.11 at 3:03 am
It looks contradictory only if you accept the ostensible “purpose” of ratings. But it’s not. They work for the banks, period (they’ll “rate a cow”, remember?). It’s just another way of cranking up the pressure. They want to strip the assets i.e. buy some islands and maybe the Acropolis for cheap. Eternal debt servitude, meh, not likely, the Greeks will eventually default anyway, that’s a sure thing. But we need to scare a bunch of people into accepting “desperate but necessary” measures. The lower the rating the higher the interest -> the more unpayable the debt -> the more desperate and pliable what’s left of the government becomes -> the sooner they capitulate. The ratings agencies are just part of a “nice cop” “bad cop” act. Seriously. You think these people don’t all get together for drinks in lower Manhattan and work this all out? They’re not stupid, you just don’t get what their intention is.
It’s a con.
stostosto 07.08.11 at 11:25 am
Unfortunately, the catch-22 may be in the nature of the situation.
SKapusniak 07.08.11 at 11:50 am
Looking at the graph it all seems very consistent to me, if you shoot yourself in the foot in terms of growth and employment by implementing austerity programs, you get down-graded because you’ve just impaired your future tax revenue and thus ability to pay…
…Oh, you thought it was a good idea to listen to what the financial elite *said* you should be doing rather than watching how they act when you actually try something? It is to laugh.
Barry 07.08.11 at 12:17 pm
Ben :
” A credit rating is a public expression of opinion. That is proper influence, not improper.”
It’s not honestly deniable that the Big Three credit agencies are simply frauds, pure and simple. The proper response for this is for the EU to extradite the upper management to face charges of fraud for their role in the housing bubble. 20 years in prison for each, and seizure of all assets for restitution would be a very good thing.
politicalfootball 07.08.11 at 1:18 pm
Well no, the evidence doesn’t bear this out. As you show, contractionary policies quite consistently lead to downgrades.
(Was the original post intended ironically? That’s what I thought at first, but upon rereading I’m not sure.)
politicalfootball 07.08.11 at 2:22 pm
Note the passive voice here. I haven’t seen evidence of ratings agencies putting pressure on governments to engage in orthodox fiscal retrenchment. Sure, there’s a Catch-22, but the ratings agencies aren’t responsible.
P O'Neill 07.08.11 at 3:36 pm
It’s worth noting that Roberto Perotti is not so gung-ho about spending cuts making for the most effective fiscal adjustments as he was widely cited as being last year. The agencies are stuck in the middle as economists rediscover that fiscal contractions are contractionary.
Niamh 07.08.11 at 5:08 pm
@17 P O’Neill, Thanks for the Perotti link. Irish commentators have long had critical things to say about ‘expansionary fiscal consolidation’, pointing out that where it seems to work, the real explanatory variables tend to include some combination of devaluation and improved export performance arising from domestic competitiveness gains and/or stronger demand due to growth in foreign markets.
More generally – The timing of some ratings changes may well be ‘political not economic’, as Barroso and Schäuble now allege. Portugal’s downgrade is certainly deeply unhelpful to them, so maybe they would say that, wouldn’t they… But we don’t have to think there’s a great international conspiracy going on in the cocktail bars of Wall Street to find the scale of the influence of the ratings agencies somewhat questionable. Investors want ratings and will pay to get them. EU leaders have proposed the need for stronger regulation of the ratings agencies, and indeed for a new European credit rating body to act as a counter-weight to the US agencies. But they haven’t done anything about it so far.
Decisive political response at EU level could reframe the relatively narrow terms on which ratings agencies make their evaluations. But the kind of actions that would shift the terms of debate are precisely those which are politically too difficult to contemplate at the moment and would probably require Treaty changes anyway (eg the capacity to issue Eurobonds so risk assessment is pooled across the Eurozone).
And yes, my final ‘very odd’ is indeed ironic. The picture of the slide in Ireland’s ratings is a sad and sorry one; readily explicable on conventional grounds; but begging many questions about the terms on which fiscal adjustment is being visited on the peripheral members of the Eurozone.
Rouge77 07.08.11 at 5:27 pm
Rating agencies are part of “soft” US power, not neutral and objective gods of the free market that see all and know all and judge without bias. Even if US government would default on it’s debts, they wouldn’t cut US ratings more than modestly. For appearances sake.
The Anglo-Saxon obsession about the failing of the euro should be left to tabloids. We have been hearing it now for a dozen years and euros ending is no closer. Your dollars and pounds are on no better ground.
Ed 07.08.11 at 6:58 pm
Rating agencies don’t care about orthodox or heterodox policies. That’s simply your projection. All rating agencies care about is, can and will you pay?
You are completely misreading this. All rating agencies look at is whether the policies support debt payment or not.
roger 07.08.11 at 7:17 pm
It seems to me that the best option for the Euro would be to simply nationalize – or Euroize – the bond market. Leaving it in private hands, while guaranteeing the banks that are the bond dealer centers, which is what has been done, is nuts. In return for guaranteeing the debts of banks, the bonds should simply be seized and burnt. And lending to states could be pretty easily done through a European Community run bank.
Ed 07.08.11 at 7:24 pm
@rouge77: Fitch is a French company and most of its country analysts are Europeans living in Europe.
T. Borg 07.08.11 at 9:41 pm
@Ed #22: “orthodox” and “heterodox” are merely useful shorthand ways of categorizing schools of thought about policy; given that policy analysis is a very important factor (“All rating agencies look at is whether the policies support debt payment or not.”) in determining “can and will you pay?” it doesn’t matter whether the OP is “projecting” the terms. He’s the one who is using them. Most people who read this probably share a reasonably close understanding of them. The terms themselves share a real-world referent with whatever terms the agencies might choose to use to describe policy as it exists or is talked about.
Unless you can somehow prove that ideology isn’t a factor in credit rating, or that there is no such thing as a traditional approach to policy, or that all acts of policy-making constitute the “traditional” without exception, “orthodox” and “heterodox” will remain appropriate terms to use in the discussion.
I think your comment was deliberately simplistic and misleading.
Ed 07.08.11 at 10:04 pm
Once again, the issue here is not orthodox vs heterodox policies. You can find highly rated sovereigns with both types of policies (as well as low rated countries), assuming we all agreed on what each policy entails.
The reason Ireland has been downgraded has nothing to do with heterodox or orthodox policies. it is the result of the massive increase in debt, the resulting unwillingness of the privat markets to continue funding Ireland, and the lack of some third party to fully take over that funding slack.
That’s it. That’s all there is to it. All analysts and market participants agree that Ireland’s ability to pay debt has diminished significantly.
Jake 07.08.11 at 11:21 pm
I’m a little confused by the original post. It reads like the ECB and the IMF are pressuring the weaker Euro countries to take austerity measures, but the rating agencies are acting like these measures are going to make default more likely rather than less likely. If you think that the austerity measures are bad ideas, don’t you want the rating agencies on your side against the IMF andECB?
Tom T. 07.09.11 at 2:09 am
18: EU leaders have proposed the need for stronger regulation of the ratings agencies, and indeed for a new European credit rating body to act as a counter-weight to the US agencies. But they haven’t done anything about it so far.
Presumably it’s politically easier to criticize the existing ratings agencies than to build new ones.
Cahal 07.09.11 at 9:58 am
“A credit rating is a public expression of opinion. That is proper influence, not improper.”
Please. Does anybody even believe this? Ratings agencies approach politicians, companies etc. and threaten them with downgrades unless they do something that benefits the banks, like privatising infrastructure.
http://michael-hudson.com/audio/Hudson_RatingJunkEconomics.mp3
There is also the tiny matter that they are paid more when they give investments a higher rating.
Andrew F. 07.09.11 at 11:24 am
Niamh @18: The timing of some ratings changes may well be ‘political not economic’, as Barroso and Schäuble now allege. Portugal’s downgrade is certainly deeply unhelpful to them, so maybe they would say that, wouldn’t they…
I don’t think “may well be” is true here. In fact I can’t think of any coherent theory that explains a downgrade of Portugal’s debt as somehow political or self-interested on the part of ratings agencies beyond their interest in maintaining a reputation for honest analysis despite pressure to do otherwise.
But we don’t have to think there’s a great international conspiracy going on in the cocktail bars of Wall Street to find the scale of the influence of the ratings agencies somewhat questionable. Investors want ratings and will pay to get them.
[my emphasis]
This is a half-truth. Investors do want ratings, and for any given security most investors will also want those ratings to be accurate.
This is the case of angry fans of a team in trouble blaming the referees for the team’s problems.
Finally, on a more general note:
Crises and generally bad news prompts governments to adopt austerity measures. But austerity measures may only reduce the increase in risk of default, and not completely ameliorate it.
For example, your business relies on a continuing stream of credit. Suddenly your income has dropped substantially, and you’re projecting much lower earnings. You promise your creditors that you will trim your credit needs. And doing so may well prevent your creditors from leaving you entirely. But your risk has increased regardless. An honest assessment would conclude your debt to be riskier.
Now let’s say you’ve trimmed your credit needs, but large shareholders think you should negotiate down payments with creditors, and half your board talks openly about how wrong you are and advocates replacing you. A creditor will wonder how stable – how reliable – your austerity measures are. The creditor is looking not just at the cuts, but at the reaction to those cuts.
And if, all the while, your company’s financial situation is worsening, and other members of your peer group are struggling… well, austerity may not be enough, and fiscal stimulus may not be enough.
Not every problem has a full solution.
Barry 07.09.11 at 12:05 pm
Ed :
” Rating agencies don’t care about orthodox or heterodox policies. That’s simply your projection. All rating agencies care about is, can and will you pay?”
Did you somehow miss the recent financial collapse?
Andrew F. 07.13.11 at 10:41 am
Another downgrade today of Ireland’s debt.
The rationale from Moody’sis that it is increasingly likely that at the end of the EU/IMF support program in 2013, private investors in Ireland’s debt will need to participate in a re-profiling of their holdings (by swapping out or rolling over some debt they own for debt of a longer maturity). This increased likelihood is supported by the EU’s clear preference for private investors to bear some of the costs of resolving the Greek debt problem, as illustrated in various comments and proposals in the last two weeks.
That preference, in turn, will have the effect of discouraging the private sector from lending money to Ireland, thereby increasing the probability that current debtholders will be required to take losses in 2013.
Moody’s does note that Ireland appears committed to its austerity program, and has made revenue and spending targets. So the concern appears to be centered around Ireland’s ability to access credit at the end of the current EU/IMF program, and the implications for current holders of Irish debt.
Barry 07.13.11 at 2:10 pm
From everything I’ve seen Ireland has two choices – default now, and take the consequences, or be drained by the EU banks until they’ve been sucked dry, and then default, and take the consequences.
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