Bill Emmott - International Author & Adviser


US downgrading? The real worry is EU default
The Times - August 8th 2011

It was a week on the wild side, and this week promises to be a tad tumultuous too, thanks to the first ever downgrading of America’s  sovereign credit rating by Standard & Poors and the latest emergency huddle of eurozone financial officials. What a surprise it would be if financial markets in fact turned out to be boring and becalmed. Fortunately for pundits and panickers that is unlikely, for the underlying situation is genuinely ambiguous: it is both better and worse than it looks.

            It is better in America than the downgrading might make it seem, and worse in Europe, which is where the real risk of default and new financial collapses lies. Even the European situation could be said to be better than it looks, however, because there is a ready solution at hand to avoid eurozone defaults. The question, though, is whether that solution is politically palatable, especially in Germany.

            Gnomic words, you may think, though no more gnomic, really, than the signals from markets during the past few days. In this supposedly disastrous week for the United States, culminating in the humiliation of the downgrade (from AAA to AA+), what did the dollar and American government bonds do? Both rose in value, which for bonds means that the country’s borrowing costs fell.

            It was, admittedly, a week when “safe havens” were popular with investors, which is why both gold and the Swiss Franc were among the winners. But it is government debt from which investors are said to be running for safety, and America is the biggest debtor of all. So it is paradoxical, to say the least, that US Treasuries were considered safe havens alongside British gilts and German bunds.

            A possible explanation is America’s sluggish growth, though it still succeeded in creating enough new jobs in June to help the unemployment rate to tick downwards. Such slow growth is disappointing but not terribly surprising: as in Britain, over-indebted households have been cutting their spending and trimming back their debts, while rising petrol prices have made them anyway feel poorer.

As long as job creation remains weak and incomes are flat or falling, growth can come only from business investment or from exports, and neither is looking hale and hearty. The one good piece of news has been the price of oil, down about 5% in the past week and back roughly to where it was at the start of the year. This reflects slowing demand, but could also, if the fall is sustained, perk up western economies a little.

            The downgrading by S&P is not surprising either. Apart from the brinkmanship over the debt ceiling, America’s squabbling politicians did what they had long been expected to do: postpone real fiscal reform until after the 2012 elections, though in doing so they entrenched a contractionary fiscal policy for the next couple of years and made any new stimulus from the Treasury impossible. Such stimulus can come only from the central bank, the Federal Reserve, which could decide this autumn on a third round of money printing by buying financial assets, as known as “quantitative easing”.

            That American picture is not pretty or politically responsible, and it leaves businesses in a fog about what will happen to taxes and public spending after 2012. Even so, the risk of any financial calamity there is small, for there is no prospect of government default and banks do not look exposed to any new dangers. It is rather rich of China (S&P rating AA-) to lecture America about the need to live within its means when it is that country’s unwillingness to allow its currency to join the modern world by being freely traded that has obliged it to buy $3 trillion worth of foreign securities, mainly US Treasuries, in order to suppress its currency’s rise.

            Schadenfreude no doubt has a good Chinese equivalent, and China may soon be using it given that it has been a boastfully keen buyer recently of government bonds from Greece, Portugal and other big eurozone debtors. In America, slow growth has led bond yields, and thus borrowing costs, to fall. In southern Europe slow growth has had the opposite effect, with Italy’s 10-year government bond yields now more than double those being paid by America and Greece’s 10-year yields more than five times America’s.

            Why? Because in the western world it is only in the eurozone where there is a known, and plausible, risk both of government debt defaults and of big new losses by banks and other financial firms. Ironically, eurozone governments have increased this risk by doing the right thing—just not completely enough.

            They did the right thing by acknowledging on July 21st that Greece cannot afford to service its huge sovereign debts, and so needs its creditors to take losses by cutting its interest rates and extending the maturity of its debts. The trouble is that it remains uncertain whether this will reduce Greece’s debts sufficiently to make it solvent. But also such losses for private creditors have cast a shadow over other southern European debts. Beyond bland political statements, no means has been found to guarantee that Greece is an exception rather than a new rule.

            This produced the entertaining spectacle in Rome of Silvio Berlusconi, Italy’s Bunga-Bunga prime minister, standing up in Parliament to say that his country was solid and faced no real crisis, and then announcing two days later a package of economic reforms intended to deal with that very crisis. If those reforms really happen, the euro will in one sense be working: it will have forced Italy to liberalise its economy, which like other southern countries it should have been doing ever since the currency was launched in 1999.

            Less entertaining, however, is the policy and political dilemma that explains why the eurozone debt crisis has not yet been resolved. Eurozone governments have a simple, but painful choice to make.

They must either decide that in a common currency, countries have to take collective responsibility for government debts issued in that currency, in which case the solution is the issuance of collectively guaranteed eurozone bonds to be swapped for Greek, Irish, Portuguese, Spanish and Italian bonds, as needed, rather as new lower-yielding “Brady bonds” were swapped for Latin American debts during the 1980s. Or, they must take the tough love route, decide that government debts remain national responsibilities, and that anyone defaulting will have to leave the eurozone.

There is no middle ground. The best bet is that the collective responsibility path will be chosen, that the euro will survive, and that the tussle will then be over what new rules and treaties are needed to stop German taxpayers’ worrying about their money being wasted by Greeks and Italians. The longer this choice is deferred, however, the greater the risk that before it is made some European bank, somewhere, will find itself unable to raise funds, and that a new chain of collapses occurs. A fresh financial crisis is not inevitable, but it is possible—unless the eurozone makes its mind up, soon.


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