What is most insidious about the credit agency warnings is the “fallacy of composition” follies it provokes. If collectively countries and investors follow their advice and governments – especially in the largest countries – fail to engage in large enough fiscal expansions – then the prospects for widespread payment problems of sovereign debt surely will occur.
BY GERALD EPSTEIN
The credit rating agencies have got us, coming and going. First they help cause the biggest economic calamity since the 1930’s. And now they tell us we can’t take the fiscal measures needed to get us out of this mess. Meanwhile, they are laughing all the way to the bank (that is, if they can find one that is still solvent). Why are we still listening to them?
The role played by the big credit rating agencies – such as Standard & Poor’s and Fitch – in the unfolding financial crisis is now well-known. By giving complex, opaque and ultimately toxic mortgage-backed securities high ratings and therefore, their own ringing stamp of approval, the credit agencies enabled banks to market these destructive securities around the world. We are now all paying the price.
Now, to prevent this very same crisis from turning into a full-blown catastrophe 1930’s-style, governments around the world – from Obama to Brown to Merkel and beyond – are finally beginning to do the right thing: they are planning major fiscal spending operations to place a floor on the terrifying downward economic spiral and to begin to turn the world economy toward recovery. Even the austerity-loving IMF is strongly supporting these initiatives.
Yet now, Standard & Poor’s and Fitch are sending “credit warnings” to other governments, threatening to downgrade their sovereign debt ratings if they “allow” their fiscal deficits to increase too much. Wednesday, Standard & Poor’s downgraded Greece’s sovereign credit rating. Explaining the downgrade, Marko Mrsnik, S&P analyst, said: “The global financial and economic crisis has, in our opinion, exacerbated an underlying loss of competitiveness in the Greek economy.” (Financial Times, January 14, 2009). And in recent days, three other eurozone countries – Portugal, Ireland and Spain – have been warned by Standard & Poor’s to “fix” their public finances or face downgrades. Under the current system, such downgrades would increase the cost of raising funds and be taken as a signal to investors to shy away from these investments.
Most significantly, these public warnings fire a shot across the bow of larger countries – such as Germany, the UK and France – that they had better not go too far down the road of fiscal expansion, or they might face a similar fate.
Yet, increasing spending and fiscal deficits in the short run is exactly what these governments should be doing. And now, after helping to cause the crisis, the credit rating agencies are blocking the way to the solution. The actions by Standard & Poor’s are therefore profoundly misguided and potentially destructive.
For starters, the implicit model used by these agencies is fundamentally flawed – especially in this crisis context. As even the IMF, financial market economists, and usual deficit hawks such as Larry Summers now recognize, as the world’s economies spiral downwards, fiscal deficits will automatically grow as tax revenues fall and spending on social safety nets increases. This will occur with no increases in discretionary counter-cyclical fiscal policy at all. Such depression-level deterioration surely will put pressure on countries’ abilities to service their debts and even risk widespread defaults or debt rescheduling. The only way, then, to improve countries’ ability and willingness to service debt in the medium term is to engage in massive fiscal expansions in the short term. But the credit rating agency models do not reflect this truth.