The real villains in the Euro debacle? The ratings agencies!

The crisis of the Euro is stalked by the ghost of Argentina - the only important industrialized  country that failed in recent memory. That was back in January 2002, when the government announced it would default on $141 billion in public sector debt.  But for the Euro debacle, the real villains are the big credit ratings agencies: Standard & Poor's, Moody's and (possibly) Dun & Bradstreet.

Ok, Greece started the ball rolling with its profligacy and corruption, and Portugal may well pick it up next, to be followed by Spain, Ireland etc. No, not Italy - people who have punned the famous PIIGS, with two II, have got it wrong, they're just the usual bunch of haughty, rain-drenched Northern Europeans who can't stand South Europeans basking in the sun. The correct term is PIGS, with the I for Italy excised. And the on-going wave of speculation attacks on the PIGS is not through yet, and it certainly isn't where Greece is concerned. Because the austerity measures required to solve the problem are bound to be politically unpalatable. As usual, the rich have taken their money out and placed it safely abroad and the poor are left to pick up the pieces. Greek banks have been depleted and their weakness was recently duly noted in the press.

The next act in the Greek drama is highly predictable: the unions will organize mass protests and general strikes, making the whole situation much, much worse. At least one major source of external revenues for Greece will be compromised. Good-bye to income from summer tourists! This is no doubt going to be a very sour and sad summer for Greece.

Ok, Germany is also a culprit. It has procrastinated because of a politically weak Chancellor, Angela Merkel, concerned with a key state election in North Rhine-Westphalia on 9 May that threatens to upset her government coalition. She stopped listening to the popular anti-Greek sentiment in Germany only when it became clear that it was not a matter of bailing out Greece but of saving the Euro. How could she take so long to realize what the stakes were? Perhaps she is instinctively anti-European - and by that I mean not commmitted to the ideal of a United Europe - because she comes from the East (she was born an East German). Most Eastern Europeans are not committed to Europe: for them joining the EU was a business opportunity, a way to finance their agriculture with EU funds and to free themselves from the shackles of Russian (ex-Soviet) influence. They did not join because they believed in Europe. If you have any doubts about that, just look at Poland and how the (now that he's dead, revered) Polish President did everything in his power to delay the signing of the Lisbon treaty and the strengthening of the EU.

But the real villains in the Euro debacle? As I said in my opening, we now know who they are: the ratings agencies! Standard and Poor's two days ago, on April 28, cut its rating of Greek government debt by a full three notches to BB-plus, the first level of speculative status. The outlook is negative, meaning the agency could downgrade Greece again. To justify this rating, S&P's cited the "political, economic, and budgetary challenges that the Greek government faces in its efforts to put the public debt burden onto a sustained downward trajectory." In short, they believe it is impossible for Greece to dig itself out of the hole it's in. Under present conditions, the austerity measures (a) are not enough and (b) if they were enough, they wouldn't  allow the Greek economy to recover so the debts can be paid back. The Greeks are dammed if they do and damned if they don't.

How credible is this piece of reasoning? Not very. It is, as often the case in this type of economic prediction, a perfect example of failure in DYNAMIC thinking. What do I mean by that?

Two things.

First, remember that predictions are always based on a reasoning of the following type: if you've got this, then you're going to get that. But you've got to make sure you don't overlook something in the situation you're looking at. Economists with their nice mathematical models make that sort of mistake all too often, because the models are only as good as their premises - never better. Miss out on one element? Then what you've got is nothing more than a classic case of TITO: Thrash In/Thrash Out. And all the complex and intellectually satisfying econometrics and mathematical modelling that has gone into it cannot change the result.

Second, a prediction is necessarily forward-looking. Time is of the essence, you have to factor it in. To be successful and credible, a prediction has to take correctly into account all the dynamics of the situation: things are a certain way today, they're going to be different tomorrow. Everything moves, nothing stays the same.This movement is sometimes imperceptible, but it's there. And this movement, more likely than not, is highly complex: it depends on a series of other moves in other related (and not so related) areas. You have to throw your mental net very wide to understand how a situation might evolve. You also need to have a lot of imagination. A mathematical model can't give you that, it's a mental straitjacket. That's why so few predictions made by economists are right - in fact, most of them are systematically wrong. It's a peculiar failure in dynamic thinking, and a very common one.

Why should credit ratings agencies who are filled with people trained in economic analysis be exempt of this failure? Of course, they're not. Ratings agencies are just as fallible as the whole economic profession. In this particular case, what is wrong with S&P's reasoning?

Simple. They've overlooked two fundamental facts, one economic and the other political.

The economic: once the Euro goes down, exports are helped. Not only German exports, but Greek exports too - including vacations in Greece that become more attractive for $$$holders. So that's your first dynamic factor that is overlooked.

The political: Greek bonds cannot be treated as vulgar corporate bonds. What does it mean, downgrading Greek government bonds to junk status? How can sovereign debt - a government's promise to redeem its debt - be equated with business debt? This is political nonsense. No global business - not even the biggest American corporation or bank - can save itself when its paper is rated junk. We've all seen what happened to Lehman Brothers. And if more big banks did not fail in the current crisis, it's because they were lucky enough to be bailed out by governments. Is the Greek government going to be left out in the cold? Obviously not. The whole of Europe is behind it - actually  the whole world, since the International Monetary Fund has joined the European Central Bank and the Commission  in the bailout of Greece.

But do governments always band together to save a brother in trouble? Here we return to the ghost of Argentina I mentioned in the beginning. It's all very simple. Argentina - politically - is not Greece. Argentina never had the kind of instant, institutionalized political support that Greece has, and I mean EU backing. It is in the interest of every Euro-zone member to shore up the Euro - actually it's in the interest of the whole world. Otherwise international trade will go to the dogs. Should the Euro crash, you could buy a spanking new BMW for $10,000! Unthinkable.

So what was Standard and Poor's thinking of when it downgraded Greece - and next moved to downgrade Portugal? Rumours are that the other agencies are about to follow. Are they serious?

It is beginning to look like the credit ratings agencies are either very stupid (i.e. unable to engage into dynamic thinking), or very corrupt. I know, I wrote corrupt. That's a  strong word and  I can't prove it. But it is a fact that the ratings agencies are paid for their analyses. A ratings agency has to make a living like everybody else! And where is the butter on their bread coming from? The corporate world. Wall Street. Anybody who's issuing bonds needs to be rated, or else the bonds won't sell. There'll be no market for them. Hence the basic role of the ratings agencies. So if you follow the quid prodest rule, you can easily see who's behind the ratings agencies and their apparently thoughtless degrading of sovereign debt...

Who?

The speculators, of course!

There's much talk about regulating the banks and hedge funds. All fine and good. But what about the ratings agencies? That's where the trouble starts and something needs to be done about it.

Regulate the ratings agencies! Now!

Any ideas how to do that? I've got some, but I'd love to hear yours...
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