How Rating Agencies are aggravating the Euro Crisis

Rating agencies Standard & Poor’s, Fitch and Moody’s are alive and kicking: the whole world quakes in the face of their credit ratings, not least most recently the governments in the eurozone. The rating agencies influence the ups and downs of European government bonds. If the agencies give the thumbs down, investors are more cautious and governments are less willing to lend, which leads to rising interest rates for new government bonds. Advocates of ratings find that quite normal; ultimately, they pay agencies to assess whether a government will end up bankrupt because of its policy. If a credit rating is downgraded, investors sell their securities to reduce their risk.

But critics argue that this is the sticking point. Rating agencies do not merely express their private opinion in the same way as the newspaper commentators. Their opinion automatically has consequences for the predicted event. Insurers, pension funds and banks are obliged by law to sell their bonds if their rating is no longer high enough. This can lead to a self-fulfilling prophecy: the rise in interest rates caused by the sale of bonds increases the likelihood of a nation going bankrupt. Tax revenue will no longer be sufficient to service debts if interest expenditure is continually rising, even if there are major expenditure cutbacks and tax hikes. Moreover, budget consolidation during the crisis wrecks the economy and increases the likelihood of bankruptcy even more.

The situation would probably not be quite so dramatic if the rating agencies were to provide adequate warning ahead of time on countries plunging into economic difficulties. Then interest rates may well rise, but not so suddenly or extensively that countries would have to make savings up to breaking point in order to pacify investors. However, experience from the last few years has shown that rating agencies rarely warn of accumulating risks and only reduce their ratings in a sudden panic when bankruptcy is just around the corner, aggravating the crisis even more.


Rating Agencies were late in their Assessments

Before the crisis, agencies in Greece or Portugal, for example, said nothing despite the constantly deteriorating competitiveness, rising foreign debt and national deficits. According to their rating, the countries were virtually risk-free. Fitch only downgraded Greece’s debts after George Papandreou, prime minister at the time, announced that the national deficit was much higher than indicated by the previous government. The extent of statistical manipulation was, perhaps, surprising, but the interested public was informed beforehand that the Greek statistics agency was not always absolutely precise in its information. Since 2004, the European Statistical Office had found fault with Greek figures, and the national deficit was revised upwards several times – without the rating agencies seeing that as cause for a downgrade.

According to a new study by the ECB, Greece’s downgrade not only led to a worsening of the financial situation in Greece, but also to the crisis spreading to other eurozone countries. Portugal’s debts, according to a press release from Moody’s, were downgraded by the rating agency based on the argument that a debt cut like the one in Greece would also be possible in Portugal. The agency completely disregarded Portuguese policy in this respect, instead focusing on Greek policy. The study also shows how the downgrade of Greek debts led to higher yields in Ireland, Portugal, Italy, Spain, Belgium and France.

It is nothing new that rating agencies keep quiet for a long time about accruing risks and then suddenly downgrading in a panic during a crisis. Right up until the major financial crisis in 2007, agencies said that the toxic securities, in which US subprime mortgages were tucked away, were completely risk-free – until those securities drove the entire global banking system to losses worth billions and pushed the global economy to the brink of the abyss. The same pattern could be seen in the Asian crisis in the late 1990s. In a study in 1999, the Nobel Prize winner Joseph Stiglitz demonstrated that downgrades by the rating agencies during the crisis made the situation in Southeast Asian economies –and hence that of millions of people – even worse.


Rating Agencies and Regulation

The main problem with rating agencies is not that they issue ratings; the main problem is that their ratings are part of regulation and that banks, insurers and other financial institutions have no choice but to structure their portfolios according to the agencies’ ratings. In the USA, this problem has been tackled through the financial market reforms of recent years, but the process is still dragging on in Europe. Reliance on rating agencies is about to be removed from US financial market regulation in the Dodd-Frank Act on financial reform. While Europe follows a similar approach in new regulation, up to now ratings are still decisive for banks and the ECB. Rating agencies are partly to blame for the aggravation of the Euro crisis. So far, politicians have done little to stop agencies from adding fuel to the fire of the Euro crisis.


  1. Michael says

    Dear Mr Lindner

    Good article, thanks for the read. There's really no other topic that boils my blood more than rating agencies; I could seriously go on a multi-page spiel, but you covered most things in finer detail (and fewer cursing). If I can just raise a few things about these agencies;

    Between 2006 and 2011, the three big rating agencies tripled their profits in Spain. Someone, somewhere is making a profit out of poverty. It is a clear conflict of interest that damages their performance and the independence of their rating; if there were a rating for the rating agencies it would undoubtedly be 'junk'. They aggrevate the crisis because they make profit from it.

    I also noticed that they tend to give these 'blessings' just before summits at the worst possible time. These agencies constantly screw up – for example Freddie Mac, Hannover Re or the toxic securities you mentioned, yet their opinions are still relied on. You may as well ask the office plant for its opinion and you'll get a more accurate picture.

    But an even more worrying article appeared in Hospodá?ské noviny (25/08/2011) which claimed that S&P have changed their criteria which will "now on will emphasize the government`s political and economic orientation"; so basically any social democratic government or any government even remotely hostile to the rating agencies or the markets or the American neo-liberal zeitgeist will be downgraded – Europe is being held to ransom. (Of course, this change in criteria was good news for the Czech government). They have aggrevated the crisis and will aggrevate the political landscape to suit their personal ideological preferences.

    Politicians have not acted against these agencies because they can't; they are held hostage. If they speak out against them then they face the threat of downgrade and thus can't raise finance (not to mention it looks bad politically). At the same time, some governments simply won't on ideological grounds (UK, Netherlands, Czech Rep etc).

    The rating agencies are very responsible for the current situation; that millions are unemployed, that basic services can't be provided, that homelessness has soared and that hundreds are committing suicide in Greece – it's their hands. There needs to be a united European voice against these pirates, and only social democrats can unite to raise a voice.

    Anyway, fully agree with what you said; but do you think Europe should do away with these agencies all together or simply regulate them more to prevent a future crisis?