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This week Ireland became the latest "eurozone peripheral economy" to see its sovereign credit rating downgraded by the credit rating agencies. This follows similar earlier downgrades of Portugal, Spain, and of course Greece. But this downgrading trend is actually good news for the European economy as a whole and truly excellent news for Germany. When money is tight—as it will be in Europe for the foreseeable future—the credit provider (Germany in this case) is strengthened. Its leadership role in Europe is becoming entrenched.
First, the recent downgrades of the weaker eurozone economies are welcome because they reflect reality. For sovereign ratings to have any value, these countries do not deserve to be at or close to the top. Given Ireland's rapid debt deterioration, it deserves its downgrade, while similarly Spain is obviously no longer an AAA credit.
Unlike Greece, the other peripheral eurozone countries are not junk—though they should pay an appropriate risk premium. Indeed, financial markets have been ahead of the credit rating agencies in applying increased risk premiums on the euro peripherals. The announcement of their downgrades hence met with a relatively muted market response.
The fact that high-debt Italy has not also been downgraded in this cycle mostly reflects its lowly starting rating (A+ at S&P, Aa2 at Moody's), as well as its muted fiscal crisis response and the light impact on Italy (relative to other peripherals) of the global recession. The rating agencies' grades will be tested by the ambition of the Italian government's medium-term structural reform program. Without a rise in the potential Italian growth rate, the size of the country's debt burden will loom ever larger.
The downgrades of Europe's weaker economies have also helped banish the blatant eurozone market failure in risk pricing, which until mid-2008 allowed every member of the eurozone to enjoy German risk levels. The reintroduction of stratified and high sovereign risk premiums in the eurozone thus ends the "free lunch" for nonreforming eurozone countries.
Instead, from now on, low market risk premiums, as well as low costs of debt financing and AAA (or close to) credit ratings, should only be awarded to eurozone countries that have taken the required structural economic reform measures. As this crisis has shown, there is no better ally of structural reforms in Europe than a skeptical bond market and critical credit rating agencies. Indeed, it would be an appropriate step for France to take note of its increasingly undeserved AAA status.
The new era of wide differences in sovereign credit ratings and high sovereign risk premiums for faltering economies is stellar news for Germany, especially as the eurozone as a whole faces low potential growth and major difficulties growing out of its debt burdens. Germany will thus see its long-term political influence in Europe skyrocket.
As witnessed during the recent crisis, German bonds are now a clear intra-eurozone safe haven. German bond yields are prone to decline in times of crisis, when the yields of peripherals rise. Thanks to its stronger fiscal outlook and external surpluses, Germany—in a future EU economic crisis—can afford simply to say "nein," sit back, watch spreads widen, and let the bond markets convince its EU partners of the need for fiscal discipline and economic reform. It would be foolish to underestimate how such "economic crisis power" translates into political power, as the other EU countries discover the costs of escalating any future conflicts with Germany.
In short, nothing will do more to diminish the French influence in the European Union than Germany's new economic safe haven status. Indeed German economic fundamentals may neutralize the advantage of France's growing population (compared to Germany's forecast decline) as a factor in the population-weighted part of the EU Council's double-majority rules, where both voting and population majorities are required for decisions to be taken.1 Growing German influence in this regard could weigh on President Nicolas Sarkozy and his potential future left-wing challengers as they seek to deal with Germany from a position of strength2 while contemplating the need for fiscal consolidation at home.
Of course this rise in German economic and political power has exacted a cost for the Germans. Germany has undergone a tough economic transition, accompanied by structural reforms of pensions and (insufficiently still) labor markets to overcome the excesses of German reunification and euro adoption. Second, Germany has agreed to provide the unprecedented anchor financing for the occasional future bailout of weaker eurozone countries through the new de facto Eurobond-financed European Financial Stability Facility (EFSF). And third, Germany has set itself a tough fiscal benchmark in the form of its constitutional "balanced budget" amendment to take effect at the federal level in 2016.3
Only if Germany adheres to its structurally balanced budget amendment will it be able to maximize its new political power in the European Union. If German governments prove capable of balancing their budgets, it furthermore makes the immediate requirement for adoption of "national balanced budget amendments" by its neighbors, or even the sanctions called for by the Stability and Growth Pact (SGP), less urgent. The markets will do Germany's work for it by enshrining Germany's safe haven status and keeping free-spending EU countries on the fiscal path of virtue.
Other EU governments are sure to be increasingly aware of the enhanced German political influence resulting from diversified sovereign risk premiums and credit ratings. The more indebted the rest of the eurozone (even the entire European Union) members become, the more powerful Germany gets. Or put in another way: For eurozone peripherals, as well as core countries (including France), lack of fiscal austerity means less political influence and ultimately fiscal sovereignty ceded to Germany.
So for eurozone peripherals contemplating what kind of sanctions regime they will accept in the coming reform of the SGP (as well as the kind of domestic structural reforms they will undertake), the real question is to where they will rather cede fiscal sovereignty—Brussels or Berlin?
It is hard, especially considering the nontrivial risk of a German overreach and potential subsequent backlash from other EU members, to think of a better reason for a credible reform of the SGP.
Notes
1. The EU Treaty lays down the member states' voting weights and the requirements for simple majority, qualified majority, or unanimity. In addition, a member state may ask for confirmation that the votes in favor of a proposal represent at least 62 percent of the total population of the European Union. If this is found not to be the case, the decision will not be adopted.
2. See a discussion of Dominique Strauss-Kahn's address to the German parliament in early May 2010.
3. Note that the German "balanced budget" amendment is a daunting fiscal challenge; it is not really a demand that the federal budget must be completely balanced. Instead it refers to close to "structural balance" (no more than 0.35 percent of GDP), which allows for countercyclical, but "nonstructural," spending to overcome future recessions. Germany state governments must balance their budgets by 2020.
