National Review, February 6, 2012

When watching a disaster movie it’s occasionally worth pausing to take stock of where the main drama, obscured by subplots, rubble, and confusion, really stands.

Standard & Poor’s announcement, on, suitably, Friday the 13th, that it had downgraded nine euro-zone countries in various disapproving ways was a chance for just such a moment. S&P’s stripping France and Austria of their highly prized triple-A ratings grabbed the headlines. The downgrades of less-than‒Black Card nations such as Cyprus, Italy, and Spain (each down two notches, to BB+, BBB+, and A, respectively) added the clickety-click of tumbling dominoes to the story. But most striking of all was the rating agency’s release of answers to questions it anticipated it would be asked about the downgrades, answers that portrayed the euro-zone crisis in ways that Angela Merkel, in particular, will not have wanted to hear.

This mess is not, explained S&P, just about the debt. While their governments’ “lack of fiscal prudence” had undeniably played a part in some countries’ arrival in the PIIGS sty, not least in the case of a certain Hellenic Republic, this was not always the case. “Spain and Ireland . . . ran an average fiscal deficit of 0.4% of GDP and a surplus of 1.6% of GDP, respectively, [between] 1999 [and] 2007,” a period in which, the agency added, a touch cattily, Germany had run a deficit averaging 2.3 percent.

So what had gone wrong? S&P makes coy references to “boom-time developments” and “the rapid expansion of European banks’ balance sheets,” but appears unwilling to spell out too bluntly how the mirage -- promoted in Brussels, Frankfurt, and elsewhere -- of economic convergence (and whispered hints of mutual support) within the euro zone did so much to set in motion the spree of mispriced lending (Irish real estate is just one of many hideous examples) that has now unraveled to such destructive effect.

That’s a shame, because publicizing the truth about those years might have helped counteract the notion, heavily pushed by the EU’s elite, that the euro zone’s troubles are the result of market failure, when in fact they are the product of just the opposite. The devastation of recent years is in no small part the consequence of economic reality’s finally returning to a space from which it had been barred by the introduction of a “one size fits all” currency that was, of course, nothing of the sort. Perhaps S&P was concerned that dwelling too much on the misdeeds of the past might further infuriate a euro-zone leadership that has fallen menacingly out of love with the rating agencies that were once its accomplices (less than two years ago S&P was, remarkably, still treating Greek debt as “investment grade”) but are now, belatedly, stumbling along the road to long-overdue repentance.

Instead, the agency looks forward. As mirages tend to do, convergence is receding: “The key underlying issue for the eurozone as a whole is one of a growing [emphasis added] divergence in competitiveness between the core and the so-called ‘periphery.’” Indeed it is, and, with monetary union meaning that the zone’s weaker members are unable to devalue themselves back into contention, any reversal of this process will be extraordinarily difficult, if not close to impossible. And, as things now stand, they may no longer even be given the opportunity to try.

Up until now the PIIGS (as S&P does not call them) have been able to manage their “underperformance . . . (manifest in sizeable external deficits) because of funding by the banking systems of the more competitive northern Eurozone economies.” That party is now over.

So what to do? S&P argues that “a greater pooling of fiscal resources and obligations as well as enhanced mutual budgetary oversight” could buoy confidence and cut the cost of borrowing for the euro zone’s weaker brethren. What these arrangements would look like is not spelled out. What they would not look like is the misshapen agreement that slunk out of Brussels in early December, a pact that S&P clearly views as too little, too vague, and too stingy.

Thus, the rating agency is understandably skeptical about whether plans to advance the start date of the €500 billion European Stability Mechanism (the permanent bailout fund designed to replace the existing €440 billion European Financial Stability Facility) by twelve months, to July 2012, will make much of a difference. Tactfully enough, S&P does not speculate whether its own downgrading of some of the countries that stand behind the ESM will make that almost certainly inadequate entity’s job even more trying. In case you wondered, it will. And in case there was any doubt about that, on January 16, S&P downgraded the EFSF.

Although it never comes out and directly says so, S&P seems to want today’s currency union to evolve into something far closer to the Brussels dream (and democratic nightmare), a fiscal union that would be the logical complement to a monetary union encompassing 17 different countries. Left unstated, but surely implicit, is that this process would be preceded by the firing of the long-awaited, effectively German-underwritten “bazooka,” the resort (however artfully described) to the monetary printing press on a scale thought (fingers crossed) to be sufficient to extinguish the euro’s growing fever. The fever is one thing, but curing the underlying disease -- the competitiveness chasm -- would be the work of generations (how long do you think it would take to build a Portugal that could keep pace with the Netherlands?), and would be an immense challenge to the social and political order in countries struggling to adapt to the theoretically admirable disciplines of a currency for which they are in fact very poorly suited.

Meanwhile, even if they can get past historic memories of what Weimar’s printing presses eventually led to, the prospect of paying for what will be, by any reasonable reckoning, a prolonged, expensive longshot is something that horrifies the taxpayers in Germany (and elsewhere in the euro zone’s north) who would be stumping up the cash. That’s why Angela Merkel, a trial-and-error politician at the best of times, will give every alternative approach a go before marching her country down a route that would enrage the electorate that is supposed to be reelecting her in 2013.

But no other alternative is likely to provide much relief for long. S&P warns that “a reform process based on a pillar of fiscal austerity alone” may well prove self-defeating. However overdue they are, and however necessary they may be to sell the bailout parade to northern voters, austerity programs on the scale now being implemented in the PIIGS suck money, confidence, and demand out of their already battered economies. They shrink the tax base to such an extent that higher rates cannot compensate for falling revenues. Policies designed to cut deficits may actually end up increasing them. The PIIGS will have been chasing their own tails.

The markets understand this well. That’s why those PIIGS that can still tap the international markets have been finding it so expensive to do so. And that’s why there is such limited trust in a European banking system (already enfeebled by the 2008–09 financial debacle) that is, directly or indirectly, dangerously exposed to the woes of the euro zone’s laggards. And when there is limited trust in the banks, credit begins to freeze up. And when credit freezes, economies slow. And when economies slow, tax revenues decline. And when they do, bad deficits get worse. And, and, and . . .

If there’s one scrap of comfort to be found in S&P’s ruminations, it is in its observation that the European Central Bank has staved off “a collapse in market confidence” by a series of measures designed to prop up the EU’s banking system. Basically, the ECB has supplied Europe’s banks with large amounts of low-priced, comparatively lightly collateralized funding that, in December, grew to include €500 billion in three-year money -- and there will be more such bonanzas to come this year. That this may have left the ECB’s balance sheet looking like the books of an unusually generous pawnbroker is a problem, but it is a problem for another day.

All that money has bought some confidence, but not, unfortunately, a lot. Contrary probably to the hopes of the ECB, the banks have not been lured into using these cheap funds to “invest” in high-yielding government bonds issued by the likes of Italy. Instead the cash just piles up -- much of it, ironically, back at the ECB -- as nervous bankers wait for the crisis in which Angela Merkel is forced to choose between deploying the bazooka that saves the euro zone but destroys her career and (much, much less likely) abandoning the euro zone and taking a leap into the unknown.

That crisis will arrive. It could be triggered by Greece, which is teetering, as I write, on the edge of disorderly default, or maybe a spreading bank run will do the trick. There are plenty of possibilities to choose from. And that’s before the black swans come into view.

Clickety-click.