What S&P’s Downgrades Mean for the Euro’s Future

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Jin Lee / Bloomberg News / Landov

Credit rating agency Standard & Poor’s dropped another market-rattling bombshell on Friday when it downgraded the long-term rating of nine – yes, nine – euro zone countries. France and Austria lost their coveted AAA status (just like the U.S. last year),  while Portugal was sent into junk territory. And S&P isn’t done yet. Its outlook on 14 nations remains negative, which, as a statement from the agency said, indicates “that we believe that there is at least a one-in-three chance that the rating will be lowered in 2012 or 2013.”

We all knew this was coming. S&P telegraphed this decision in early December, and, after the big U.S. downgrade last year, it seems inevitable that France and others would be stripped of their top rating as well… But just because you see a punch coming doesn’t mean it won’t hurt when it lands. S&P gave the euro zone a fat lip on Friday, calling out its political leadership for its tepid response to the mounting crisis, and warning that the situation could get much worse. German Chancellor Angela Merkel used S&P’s action as a call to arms for swifter action. Perhaps the downgrades will prove a positive by heightening the urgency of euro zone reform.

But maybe not. S&P’s decision tells us something even greater about what’s happening in Europe. It exposes the seriousness of the sacrifices the nations of the euro zone must make to keep the common currency alive. And in that way, the downgrades could be as much an impediment as a cause for euro zone reform.

From the standpoint of Europe’s leaders, that reform process has been moving along in the right direction. In December, they agreed to toughen rules and sanctions on deficits and debt in a step towards closer fiscal coordination. They are also accelerating the introduction of a permanent bailout fund to replace the current one (the European Financial Stability Facility). Yet in explaining its decision, S&P stated bluntly what investors have been fretting about since the debt crisis began more than two years ago: European leaders just aren’t doing enough, to tackle the problems facing the monetary union. The proposed solutions are neither providing enough support for struggling countries nor bringing about sufficient structural changes to the way the euro zone works. Here’s more from S&P:

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…The outcomes from the EU summit on Dec. 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.

Perhaps more importantly, though, S&P noted that the entire approach Europe’s leaders have taken to the debt crisis is misguided and misinterprets its real causes:

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.

In other words, by focusing primarily on fiscal austerity and liquidity support, Europe has entered a race to the bottom. The more budgets get cut and taxes go up, the weaker economies become. That makes it harder to meet fiscal targets or stabilize debt, leading to more cutting and tax hikes and even slower growth, and so on and so on. Economies enter recessions (which is already happening across Europe), making reform more difficult and spooking investors, causing borrowing rates to rise and putting more pressure on national finances. It’s a deadly spiral. By simply imposing more rules on fiscal policy – the basis of a German-inspired vision for a more integrated euro zone – Europe’s leaders are setting targets many members can only meet through extensive suffering, and thus, the new drive for reform of the euro zone can make the debt crisis worse, not better. What’s missing in the reform equation is the other side of integration – not just more dictates and rules, but deeper policy coordination to spur growth and help weaker economies. Instead of an “austerity union” now being pursued, the euro zone needs a true fiscal union, one that doesn’t just penalize rule-breakers, but also uses tax and budgetary coordination to assist debt-ridden economies return to health. That could include a “eurobond” or other methods towards at least partial debt consolidation. Along with a beefier bailout fund, the euro zone must engage in policy changes across its members to reduce imbalances and aid less competitive economies find growth. We’re not seeing any of this happen.

That’s because the S&P downgrades also show the risks of taking such measures. The more integrated the countries of the euro zone become, the more they share each other’s problems. The mass downgrade in Europe is a reflection of how stronger economies (like France) are being dragged down by their exposure to their sick neighbors. Further integration will only intensify that exposure. Is that where the stronger nations of the euro zone are willing to go? So far, they’ve shown no inclination of such willingness. That’s why we’re getting new rules imposed on the debt-plagued economies of Europe and not more resources. Facing potential voter outrage at home, those nations with the money to help (like Germany) have been trying to limit their potential losses from the euro instead of stepping in to tackle the monetary union’s real problems. Now we have these downgrades. In France, as my colleague Bruce Crumley pointed out, the loss of AAA status is already a blow to President Nicolas Sarkozy, with an election only weeks away. Can France commit to even deeper integration that could further eat away at its economic standing? I think it will be difficult. The S&P downgrades have shown the type of sacrifice euro zone nations will need to make to escape the debt crisis – sacrifices they may not be willing to make.

So here we have to real source of the euro zone’s weakness. At the end of the day, despite all of the talk about the euro’s mission of peace and democracy, the monetary union is becoming a boxing match over who bears the burden of reform. Germany and France want Italy, Spain and Greece to take the body blows so they don’t have to. We see the same contest taking place between the private and public sectors. Talks between the Greek government and its creditors have broken down over the level of losses private bondholders should absorb in the so-called “voluntary” restructuring of Greek debt proposed as part of a second bailout for the country.

Until the leaders of Europe find a way to share sacrifices and allocate losses, the debt crisis will continue to spiral downwards and Europe will remain the biggest threat to global economic stability. If the current direction continues, it may only take a few more rounds before the debt crisis finally delivers the knock-out punch to the euro, and Europe’s dream of integration.