By Paolo von Schirach
January 13, 2012
WASHINGTON – Only yesterday the international business media sounded very optimistic about the Eurozone. They reported that Mario Draghi, president of the European Central Bank now thinks that the situation has been stabilized. Auctions for short and medium term Italian and Spanish bonds had gone well. Yields are down. So, is Europe finally out of the woods? Well, not so fast. Today, Standard & Poor’s downgraded half the Eurozone, including (supposedly) recovering Spain and Italy. And France lost its coveted AAA rating.
S&P pesssimistic outlook
Beyond the action that was expected and therefore largely priced in by the markets, it is important to read the motivation provided by this key credit rating agency, because it presents a totally unflattering and pessimistic picture of Europe’s ability to eventually get out of this mess. In other words, this S&P credit downgrading most likely is not going to be the last, unless policy makers change course. And S&P does not believe that they will. Here is an excerpt from a much longer S&P statement:
“….Today’s rating actions are primarily driven by our assessment that the policy initiatives that have been taken by European policymakers in recent weeks may be insufficient to fully address ongoing systemic stresses in the eurozone. In our view, these stresses include: (1) tightening credit conditions, (2) an increase in risk premiums for a widening group of eurozone issuers, (3) a simultaneous attempt to delever by governments and households, (4) weakening economic growth prospects, and (5) an open and prolonged dispute among European policymakers over the proper approach to address challenges.
The outcomes from the EU summit on December 9, 2011, and subsequent statements from policymakers, lead us to believe that the agreement reached has not produced a breakthrough of sufficient size and scope to fully address the eurozone’s financial problems. In our opinion, the political agreement does not supply sufficient additional resources or operational flexibility to bolster European rescue operations, or extend enough support for those eurozone sovereigns subjected to heightened market pressures.
We also believe that the agreement is predicated on only a partial recognition of the source of the crisis: that the current financial turmoil stems primarily from fiscal profligacy at the periphery of the eurozone. In our view, however, the financial problems facing the eurozone are as much a consequence of rising external imbalances and divergences in competitiveness between the eurozone’s core and the so-called “periphery”. As such, we believe that a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand falls in line with consumers’ rising concerns about job security and disposable incomes, eroding national tax revenues…..”
S&P identified systemic flaws, more downgrades to come?
So, according to S&P, despite the great optimism after the latest EU summit, policy measures taken so far are insufficient. Worse yet, there is a failure to recognize that the crisis is largely due to lack of competitiveness resulting in economic weakness. There is lack of understanding that austerity alone, without credible growth policies, makes matters worse because it sucks even more resources from anemic economies.
Beyond the polite formal language, S&P downgraded many Eurozone countries because the EU policies aimed at solving this more than two year long crisis do not add up. Which is to say that the plethora of EU summits and solemn declarations and unity pledges are inadequate and not credible. Amazingly enough, after all this time, the EU has yet to attack the problem in a convincing way. (Translated in simple language: they do not not how, or they are too afraid to take bold steps). Hence this raft of downgrades.
Italy’s outlook is not good
But let’s look at some specifics. Let’s look at Italy as a good illustration of a half baked plan. In the Fall, when the situation was dire, the ethically challenged perennial Prime Minister Silvio Berlusconi was forced out of office, for the good of Italy. In his place comes a dignified non politician: Mario Monti, President of the prestigious Bocconi University in Milan, former EU Commissioner and internationally respected economist. This change at the top alone was supposed to inspire markets as they would finally see a serious person in charge. To his credit, Monti and his technocratic government of non political experts, went to work on some more austerity measures aimed at showing lenders that Italy is serious about cutting spending.
A growth strategy?
But after Monti did that, all observers started asking about his plan to kick start growth in a stagnating Italian economy. Well, there is no real plan. Sure enough, there are some initiatives at liberalizing access to professions and economic activities. But even timid talk about introducing real labor mobility was met with ferocious labor unions’s reactions. No, sir. Our coveted right to life time employment is not for discussion. And liberalization efforts are met with equal resistance from all those who stand to lose equally coveted rent positions based on restricted access.
Worse yet, the old and time tested Italian bad habits are still there. As soon as Monti came into office, a major political scandal linking parties, partially state owned corporations Finmeccanica and public contracts exploded. Most recently, Carlo Malinconico, his very own undersecretary to the Prime Minister, (the equivalent of a Cabinet Secretary) , had to resign because of a cloud of suspicion regarding shady past dealing with questionable economic entities. And the Italian Chamber of Deputies just refused to lift the immunity protecting one of its members, Nicola Cosentino, from prosecution for alleged connections with the Casalese clan, part of Camorra, Naples’ most powerful criminal organization.
With all this, no wonder that Italy has very poor ratings on corruption from Transparency International, while it scores badly within the World Bank’s ”Doing Business” tabulations that rank all countries on the easiness to conduct routine economic operations and on the efficiency of public services that should support business activities.
The spread between German and Italian bonds
And, Mario Monti wonders why Italy is forced to pay more than 6.5% interest on its 10 year bonds, while Germany pays less than 2%? The answer is simple. Because Italy has bad governance and low ethical standards. The country is systemically weak and there is no sign that this will improve. Simply put, in the short term the government can raise taxes an d reduce the deficit, as it did. But if this is all the ammunition they’ve got, the battle is lost.
Just a few notches ahead of a Banana Republic
With all due respect for Monti’s personal integrity and skills, he is governing a country just a few notches ahead of a Banana Republic. In order to have meaningful growth, (and that means at least double the miserable 1% that Italy had in the last few years), in this super competitive, globalized world you need good governance, excellent public services, modern policies, first class entrepreneurs and flexible, adaptable labor markets. I see none of that in Italy and, Monti’s reform efforts notwithstanding, a slim chance of making any of this happen. Hence the S&P downgrades and the almost 5% spread between Italian and German 10 year bonds.