About Credit Rating Agencies and the root of the crisis in Europe

2011-12-31

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Credit Rating Agencies have a central role in the crisis of the Euro. Their downgrades are much feared by European policy-makers who are trying to cope with the mounting pressures on their single currency and its constituent member-states. Over the years of the crisis these downgrades are considered among the primary sources of the negative dynamics against sovereigns who were experiencing serious debt crises. Greece was the first to experience a series of consequent credit downgrades, eventually becoming unable to raise money from the international bond markets, thus coming to the need of a bailout mechanism, to prevent an official bankruptcy. Ireland and Portugal had a similar fate. Currently bigger Euro member-states, such as Italy and France (and not only) are also threatened by such downgrades. The approach much of the European leadership and the intelligentsia has held vis a vis Credit Rating Agencies, is that their actions are either suspicious or biased, certainly not reflecting the truth of what actually is the case in the European interior. Before commenting on the “official” position I need to present a few facts about these credit Rating Agencies, their role and the way they were treated prior to the crash of 2008 by almost all governments and institutions.

**Facts about Credit Rating Agencies**

First of all by Credit Rating Agencies I am referring to the three major agencies, namely Moody’s, Standard & Poors and Fitch. Those played a sinister role in the housing bubble in the United States, whose burst led to the collapse of Wall Street that caused the Great Recession (soon it will be four years old). The details are not important for now, but in general they provided top-notch ratings to “investments” (financial derivatives) that ended up being nothing but thin air, such as the infamous Collateralized Debt Obligations (CDO) of Lehman Brothers. This (among others) propped up the bubble, levered up banks, increased household debts, exposed more and more entities to the bubble, eventually causing what we have all been experiencing, ever since, not only in the form of the recession (reduced income – increased taxes), but also via massive bailouts to these same banks who took the money to then speculate against the hand that fed them – the states. The crash of 2008 has taught us two lessons with respect to Credit Rating Agencies: (i) that they were effectively tools to the crime by reinforcing speculation, (ii) that investors no longer show the same faith in them, but seek many other sources of information instead to evaluate their planned actions; this is also made clear by the fact that credit downgrades always come after a run on sovereign bonds that had already been well underway.

Second fact is governments, international institutions and major central banks such as the European Central Bank all showed trust in the evaluations of these Credit Rating Agencies. The ECB for instance was officially using their reports as a main input to evaluate the condition of the European financial system. It is unacceptable to have a European institution, a central bank who is among the most respected central banks in the globe, to offer such an important status (and thus power) to some private corporations. The purpose here is not to criticize the ECB in particular. The gist is that institutions, states, officials, were those who gave great power to Credit Rating Agencies. It is they who made credit ratings, and most importantly downgrades, comparable only to the “thumbs down” gladiators faced at the Colosseum in Ancient Rome (thumbs down meant death to the losing fighter).

With the above two in mind we can draw the following conclusions so far: (1) Credit Rating Agencies are not trustworthy, as they serve particular interests even though their ratings can occasionally reflect the truth, (2) their influence and power was increased dramatically thanks to the treatment they enjoyed by states and central banks across the world. These findings will now allow us to argue in favor or against the accusations of bias and suspicious behavior, coming from European policy-makers and intellectuals by considering the actual parameters of the Eurocrisis.

**The Eurocrisis in short**

The first fact is that the crisis in Europe is caused by the serious flaws in the architecture of the euro. These are the structural trade imbalances between periphery and center, the absence of a genuine fiscal union that would include a common treasury with the power to raise revenue, transfer funds, issue bonds of its own and the lack of a unified banking sector with harmonized supervision and regulation at a European level (other political and social issues are also integral, but are omitted for the sake of remaining focused on the article’s subject). The crisis in Europe is self-fulfilling, since quasi-bankrupt banks hold the debt of stressed sovereigns – a vicious cycle that is reinforced by the absence of stabilizing mechanisms, of a circuit brake so to speak.

The second fact about the Eurocrisis is that bond investors are to a large extend European banks, who need not the advice of Credit Rating Agencies as they know better what is happening in their own states; while the rest of the international investors no longer attribute the same value to the ratings of the three major Credit Rating Agencies, because of their sinful past.

**Conclusions**

A good doctor is one who is capable of diagnosing the source of the illness, so as to provide a cure to it, if such a remedy exists. Similarly an objective analyst will have to identify the source of the trouble in Europe to suggest a solution, if such exists. With all of the above in mind my account is that the crisis is not caused nor reinforced by the doings of Credit Rating Agencies. I am not saying that they are not speculators, nor do I suggest that they are not to be blamed. I am only stating that the root of the crisis in Europe is internal.

The malignancies of the eurozone were numerous. Over-leveraged banks, highly indebted states, a European growth model that wastes resources and retards potential growth, a welfare system that functions as an obstacle to growth rather than a factor of it, an institutional framework that is highly bureaucratic, cumbersome and ineffective and finally a European Union that is increasing its structural democratic deficit and the distance it has from its citizens. These major issues, together with many others are all internal issues that are at the root of the crisis in Europe. Europeans themselves are the first to be blamed for what they are facing. After all speculation is the symptom not the cause. There can be no speculation over a robust economy, just like hyenas cannot attack a healthy lion.

The discussion against Credit Rating Agencies is but a red-herring, an attempt to put the blame on someone else. Yes they may be suspicious, yes they may be biased, yes they may be engaging in speculative behavior. But the source of the problem is the manner in which European integration was realized over the decades. It is the way in which Europeans envisioned their common future. It is the fault of Europeans who managed to create such a perverse and ill-shaped a structure, such as the whole European Union and in particular the Euro.

Europe will escape from the crisis only when it decides to face itself in the mirror. Only with self-criticism — with cynicism — will Europeans overcome their collective problems. Putting the blame on outside forces is an excuse that will cost Europe dearly.