Throwing the Bond Market Out With the Bath Water

The war the EU has declared on the ratings agencies shows why investors should not underestimate its determination to scapegoat “Anglo-Saxon” speculators for the sovereign debt crisis, and reduce “excessive profits” in the financial sector.

The ratings agencies may have been slow to react to economic data that showed many currencies slipping into a debt-deflationary spiral, but Moody’s really had no choice but to downgrade Portugal four notches to junk status. Buying time was never going to fix the sovereign debt crisis, especially given Merkel’s determination to scare off the pension funds. However, by insisting on “burden sharing” for private holders of Greek debt, EU leaders have made a wider restructuring of debt in peripheral countries like Portugal inevitable.

Financial contagion, which spread to Italy last week, now threatens to spiral out of control. But instead of acknowledging their mistakes, the euro-zone’s panicked leaders are conforming to type and falling back on populist anti-capitalist rhetoric – perhaps to deflect blame from themselves for the eventual demise of the euro.

Past form suggests they are not be bluffing when they talk of banning the ratings agencies outright, or “breaking their oligopoly” to prevent them “fanning the flames of speculation.” After the banking crisis was blamed on “locust” hedge funds – rather than excessive debt – it didn’t take long for the EU to produce legislation to rein them in.

So when Michel Barnier, the EU commissioner for financial regulation, warns credit ratings agencies to be “extremely careful to fully respect” EU regulations, the markets should take him deadly seriously. His pan-EU oversight body already has binding powers to breathe down the ratings agencies’ necks. The EU’s landmark regulation on credit rating agencies came into force as recently as December 2010 (EC/1060/2009), and hands the bloc’s new markets regulator, the European Securities & Markets Authority, supervisory powers.

Manuel Barroso, the European Commission president, says the EU is planning stricter oversight of Moody’s, Standard and Poor’s, and Fitch. Brussels will examine issues of “civil liability” for inappropriate assessments by the agencies on the credit worthiness of sovereign European countries, and draft restrictive legislation by the end of the year.

“It seems strange that there is not a single rating agency in Europe. It shows that there may be some bias in the markets when it comes to the evaluation of the specific issues of Europe,” says Barosso. MEPs agree. In a non-legislative report by German MEP Wolf Klinz, they have recommended the setting up of an EU-wide ratings agency, funded temporarily from the public purse, in a bid to avoid the conflicts of interest they say are endemic where banks pay for their own ratings.

Anyone who is economically literate knows that imposing official EU credit ratings on the bond market would plunge them into chaos, because scared investors would dump European debt. But then Europe’s leaders, who know how to play to the far left – because so many have roots in it – have never really understood how markets work. They may actually believe that muzzling free speech will fool the bond markets.

Meanwhile, the European Parliament is also attempting to rid the EU of the speculators betting on Greece going bankrupt, by voting for a ban on the practice of naked short-selling of credit default swaps. This would, of course, cause the trading in sovereign bonds to dry up, leaving governments short of cash. But in the present economic and political climate it would be unwise to bet against the EU cutting off its nose to spite its face.

Related: Choices For Greece, All Daunting [New York Times]