Downgrading France

One of the problems with the rating agencies’ assessments of the debt of major country governments is that they are too newsworthy. As a result, they appear to be much more important than they actually are. Jonathan Portes, before he started his own blog, had a healthily unbalanced assessment of their competence here.

                Having said this, Stephanie Flanders (and subsequently Paul Krugman) is absolutely right to focus on something interesting in S&P’s justification for removing AAA from France and downgrading other Eurozone economies. To quote from S&P:

We also believe that the [9^th Dec] 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 EMU'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.

It is good that the competitiveness issue that I discussed here is now considered as serious a problem as any fiscal profligacy. It is also good that the possibility that fiscal austerity could go too far is being raised. Until recently, the general view seemed to be: the more austerity the better.  

                However, there is a danger of inconsistency in all this. Let us focus on the competitiveness issue. To correct this problem, we need inflation in uncompetitive Eurozone countries to be below German inflation. To achieve this, we almost certainly need a period in which domestic demand in those countries is weak relative to Germany. That has already happened to a considerable extent. The key question, which I raised here, is whether what has been done already is enough, or whether the gap – in simplistic terms – between non-German and German unemployment needs to be greater still. If inflation forecasts are to be believed, competitiveness correction appears to be painfully slow, reflecting perhaps the difficulty in reducing inflation outside Germany when it is already very low.

                Of course it would be great if governments outside Germany could take measures that helped competitiveness without harming growth, but the group of such measures may be an empty set. It probably is the case that some measures may have more of an immediate impact on costs than others, and so if policy could focus more on the competitiveness problem that might help. But the real issue here is Germany.

                It is the outlook for Germany that makes everything so difficult. The OECD’s forecast is that German output will be below the level that will stabilise inflation over the next two years. This keeps German inflation low, making it that much harder for other countries to regain competitiveness. The Euro area desperately needs a much more rapid expansion in Germany, so that German inflation rises well above 2%. If the forecasts that this will not happen are correct, there is one policy instrument that is available that could turn this around, and that is fiscal expansion in Germany. (Yes, some more from the ECB would help too, but it is the relative position of Germany within the Eurozone that is key.) What S&P and others should be saying is: we need a large, quick but temporary increase in public spending in Germany to save the Euro.