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Net Net: Promoting innovation and managing change

Why S&P Ratings Threats Could Help Save Europe


If European policymakers were looking for further impetus to get a workable solution in place to their debt crisis, Standard & Poor’s may have provided it.

The ratings agency warned that the euro zone’s largest economies are in peril of seeing their credit downgraded unless a solution occurs to deal with the sovereign debt issues plaguing mostly southern Europe.

Should the nations in question need any reminder of what happens to investor confidence in the event of a downgrade, they need look no further than the U.S.

When S&P cut its view of American debt in August, equity markets responded with a 4 percent one-day tumble, tipping off a market funk that lasted into early October.

As such, the lackluster policy response so far to the European crisis should get a jolt from the agency’s threats.

“Negotiations have turned away from short-sighted stabs at finding sufficient financial firepower with which to buttress wayward governments,” Andrew Wilkinson, chief economic strategist at Miller Tabak in New York said in an analysis of the European situation. “Now they are prepared to face head-on the sizeable reality that a loss of investor confidence will lead to the cremation of the euro currency in its present form without even pronouncing its death.”

Interestingly, Wilkinson posits that the S&P saber rattling “and the ramifications of a failure this week should already be baked in the cake.”

This is pretty much what everyone thought when S&P downgraded U.S. debt.

Well-telegraphed though it was, the actual decision still shocked investors who assumed it was well known that American finances were in shambles. A market known more for buying rumors and selling news did just the opposite, reaching a 2011 peak two weeks before the announcement. The market currently is still 6.5 percent below the high-water mark.

Perhaps, then, a reality check relative to expectations is in order.

Willem Buiter, Citigroup’s widely followed chief economists, published a dialogue Tuesday with someone identified only as Concerned Market Observer dissecting the state of affairs in Europe. It is an enlightening if a bit wonky look into the limited options for stemming the crisis, which Buiter believes will be bad but not catastrophic.

He asserts that grand-scale debt restructuring, both public and private, will be necessary to get Europe going again, and even that will happen only after a long, painful process. But he expects the entities involved to do enough to prevent the restructurings from being disorderly and thus creating havoc through the global system.

The closing exchange in Buiter’s note:

Concerned Market Observer: Will this be enough to get the ECB to buy periphery debt in large enough scale to drive yields down to levels that put Italy and Spain on a sustainable path (i.e. sub 5 percent and probably well below that)? I doubt it. More likely, the ECB will buy enough to put yields at 6-8 percent, a level which leads to economic depression and slow fiscal insolvency. Conclusion: the summit will have done enough to prevent near-term disintegration of the system, but will have failed to resolve the crisis.

Buiter: Secondary market prices will be decoupled from sovereign funding costs for

Italy, Spain and other troubled sovereigns. This will make for continued high market yields and will contribute to weak economic activity, most likely continued recessions.

Either the sovereigns that matter will, after many years of austerity, restore solvency or there will be orderly restructuring of Italy, Spain et. al. in addition to Greece,

Portugal and Ireland. I call that solving the crisis. Slow growth or negative growth with high and/or rising unemployment is the new normal for the EA, the UK, Japan and the US, unless non-market ways of restructuring excessive sovereign, bank and household debt are pursued. Even then, potential output growth is likely to be modest, well below levels deemed feasible prior to the crisis, especially in the US and the UK. Reasons are demographics, worsening quality of human capital, inadequate infrastructure and a tendency towards over-regulation in the financial sector.

Lousy prospects, but not a crisis.

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