A Double-Edged Sword

After the recent decision by Standard & Poor’s to downgrade nine Euro-zone economies - including France, Italy, and Spain - rating agencies are once again at the centre of controversy. As European governments try to push through painful cuts and reforms, the prospect of moving goal posts is little short of a nightmare. It threatens to undo some of the progress and further increase the pressure on politicians who have to not only run their crisis-struck countries but also fight elections in the face of an increasingly irritable and impatient electorate as economic growth is proving ever more elusive. Many are choosing to deal with the situation by criticising the rating agencies, forgetting the old adage: Don’t shoot the messenger.

Few can argue with the basic economic realities that have been used to justify the downgrades. But the agencies are vulnerable in other areas well. The most compelling economic - rather than political - criticism of the growing pressure from the agencies is that their actions are proving pro-cyclical. By tightening the screw at a time of crisis, they risk worsening the downturn. By pushing up the cost of borrowing, they risk weakening economic growth even further and adding to the vulnerabilities of the already shaken banking sector. The extreme scenario is a vicious, self-reinforcing downward spiral. Conversely, it was doubtless in part the rating agencies that fuelled an ultimately unsustainable boom in the pre-crisis days by assigning top credit ratings to mortgage-backed securities marred by sub-prime mortgages. By now seemingly punishing countries that are trying to undertake reforms they seem to many to be adding insult to injury.

But in fairness, the rating agencies are, however indirectly, making an important point. A flexible economy will require also political nimbleness, a system that is capable to taking tough decisions when they are called for. The pernicious legacy of the ‘Great Moderation’ was a very low political pain threshold as no one wanted to embrace difficult choices. They were consequently often postponed, underpinned by the illusion that economic cycles were a thing of the past. Historically speaking, tough choices tend to require the kind of discipline that only results from a genuine lack of alternatives. The Western nations above all have spent several years of the crisis thinking that they have an alternative when it is clear that the one-time credit-fueled bubble cannot be patched up. This mentality cannot be sustained for ever and any attempt to do so will only increase the economic pain facing the continent. Anyone needing to be convinced of the dangers associated with such illusions only needs to visit Japan or revisit the economic history of the country over the past two lost decades.

A more valid concern is the risk that the disciplinary effects of the downgrades may push countries towards greater, and potentially irresponsible creativity in other areas, most notably monetary policy. Do European countries need loose monetary policy? In many cases no. Ultra-loose monetary policy has resulted in a period of negative real interest rates which is bad from the perspective of efficient allocation of capital. Nonetheless, the pernicious effects of monetary policy creativity may well be the lesser of two evils at a time when fiscal credibility and structural reform are important for a whole host of reasons. After all, monetary policy will be far easier to tighten than fiscal policy should the circumstances change. But in the near term, monetary policy is likely to serve as the only real source of flexibility for countries seeking manage the costs of unprecedented economic adjustments without the erstwhile option of competitive devaluations. Moreover, a looser monetary stance will weaken the Euro, which will serve as a source of some flexibility. Moreover, let us not forget that a looser monetary policy will become unavoidable should the Euro-zone break up. So why not use it proactively to prevent such an outcome.

It is clear that Europe desperately needs the kind of structural reforms that will shift economic activity from the public to the private sector, will result in significantly more flexible labour markets and more effective resource utilisation, and will reduce the culture of welfare dependency that emerged during the years of plenty. The only way out of the crisis is hard work and greater efficiency. It is only fair that some policy options are used to reduce the necessary pain but the added flexibility should not be squandered but rather taken to push through the kinds of reforms that are a pre-condition for preventing a repeat of the crisis. The most competitive and resilient European economies today are ones that used previous crises as an opportunity to push through overdue reforms. To think that the rest of Europe is any different is yet another illusion and a recipe for disaster.

Is it valid to argue that the agencies are treating Europe unfairly as compared to the US? To an extent, yes. The fiscal unsustainability of the US is little different from many European countries. Yet the Dollar has once again regained its safe haven status and bad news in Europe will only strengthen it, although the US is making minimal progress towards the necessary reforms. Nonetheless, it should be obvious that the EU can combine its structural reforms with US-style monetary flexibility and, to the extent that the reforms are successful, the rating agencies should stand ready to reward Europe.

From the rating agencies’ perspective, the recent decisions, however controversial, make sense. Not only are past oversights not a valid excuse for making yet more mistakes, but it is also clear that market pressures remain the most effective ways of creating the necessary backing for reforms. A lack of competitiveness can only be overcome by restoring competitiveness through deliberate, focused policy action. Monetary flexibility is needed not only to ease the economic pain but also to contain the political resistance that such reforms would otherwise encounter. This reality must be talked about more openly than it has been. The lack of the devaluation option - which in the past was used to ease the pain of adjustments, however limited its effectiveness - must not mean a total lack of alternatives. I believe that Europe remains capable of handling and overcoming the crisis but the time for action is now. After all, this is the key message of the rating agencies as well.

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