On sovereign ratings of Italy, perhaps a little, unconscious bias & a rare economist I trust

…if you had paid any attention to the ratings these past few years you would have lost a lot of money…

Erik F. Nielsen’s “Sunday Wrap Up” tackles, today, Italy’s sovereign debt downgrading.


Once again, I love Erik’s clarity on the subject. I will let him speak, then:

S&P downgrades Italy

On Friday, Standard & Poors cut Italy’s sovereign credit rating from BBB to BBB-, citing weak growth and poor competitiveness, which are seen as undermining the sovereign debt sustainability. (Little appreciation for the fact that some of the growth problems should be temporary due to recent years’ ambitious fiscal policies.)

It is a peculiar decision, which does not reflect any new hard information, but rather the lack of visibility in that smoky room in which the rating agencies’ credit committees over-ride the analysts’ objective data input.

In a paper Daniel Vernazza, Vas Gkionakis and I published in March (“The Damaging Bias of Sovereign Ratings”; UniCredit Global Themes Series; 26 March 2014) we documented how systematically wrong the agencies’ “subjective component” (i.e. the committees’ over-riding of the “objective input”) has been over the years. (As you may recall, our paper received a lot of media attention, and has since been quoted by several academics. The three major rating agencies received plenty of invitations to respond, which they didn’t do beyond some brief statements to the FT that this couldn’t be right … well, it is.)

But here is the biggest picture: Having been badly burned during the Asian crisis, the three major agencies took no chance once the European crisis emerged, massively downgrading the periphery between 2009-11 – de facto running after markets, of course. Of course, if you had paid any attention to the ratings these past few years you would have lost a lot of money.

There were two key consequences of those massive downgrades: First the tragic one. Because regulations remain tied to ratings (that regulation indeed ties its policy to judgements by a for-profit oligopoly with terrible track records remains beyond me), a whopping USD 1.5 trillion was withdrawn from the periphery during this period, seriously worsening the crisis.

Second, having ignored their own data input during those three years, the ratings for the Eurozone periphery ended up 4-5 notches below what the three rating agencies’ own published data input for the ratings told them the ratings should have been. Since then, we have seen several upgrades of the periphery as the process of reparation of their past mistake got under way. Struggling to understand Italy keeps Italy 3-4 notches under-rated compared to its fundamentals, as defined by the rating agencies’ own manuals.

Italy surely has a lot of issues, but the rating agencies’ obsession with the public debt numbers is out of proportion. First, they ignore that the debt is owed primarily to domestic Italians (vastly reducing the amount of resources having to be transferred abroad, and vastly reducing any government’s incentive to restructure). Second, they ignore the fact that the Italian government’s contingent liabilities (including future pensions and healthcare) are among the lowest in the OECD. Indeed if you add explicit and implicit liabilities, the Italian government is about the least indebted government in the OECD (I am not arguing that a simple addition is appropriate, but ignoring contingent liabilities surely isn’t appropriate either.)

We economists all make mistakes, and when we meet at various conferences most of us usually have a good discussion of what went right and what went wrong – and we learn something from it. We all know it’s a probability game, but here is the point: The probability of getting it right improves when you stick to the data input. When you don’t, well then its “just an opinion” based on little facts – and, hey, that’s fine too, if anyone cares to listen. That our policymakers continue to tie regulation to “just opinions” by a few for-profit-agencies (with quite limited budgets for macro research), thereby impacting systemically important capital flows, is a travesty.

Until they change this link, we’ll live in a world with unnecessary volatility and systemic risks – and “real money” guys struggling to make a return for their pensioners.

Thank you Erik.

Tommaso Arenare


Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s