Finance is fun again!

The credit rating agencies have warned that all of the euro zone countries may be downrated over the next few months. Why do we listen to these self-appointed guardians of the debt market? Do they have any superior skill in judging the ability of countries like Germany, France or indeed Italy to pay their way? When one looks at their recent history one is forced to wonder why we give them air-time.

It is not as if their pronouncements are backed by sophisticated economic or financial modelling - not a bit of it. A clutch of ill-defined ratios here, a bit of financial gobbledespeak there and the financial world goes into meltdown. Default risk analysis is not easy and as my early work in dynamical systems theory and catastrophe modelling demonstrated the results from the conventional multivariate models can be deeply ambiguous. It is perfectly possible for two companies / countries to record exactly the same values for exactly the same metrics and one survive and the other be in failure. This 'gray' zone is further widened when dealing with countries who are as heavily interlocked as those in the euro zone.

So given all of this is there really a crisis? I think there is and it is because we have talked our way into it. Until 2008, the major economies were (more or less) structurally sound, countries have to raise debt for capital infrastructure and the more advanced they are the more they need. However, the banking crisis tipped many countries into a deep recession where, in the UK for instance, 7 per cent of GDP was lost. That's a huge shortfall in revenues against expenditure and countries had to borrow to bridge the gap. The response was initially correct in the UK: apply stimulus to kick start growth and once it was well underway start the process of paying down the debt. But then the rhetoric of an election took over and if there is one big mistake this government has made it is to talk 'dirty' about the economy. In the eurozone the ability to apply stimulus is very limited - QE is a dirty term to the Germans and the only body that could do that would be the ECB. What this crisis has been all about is bringing the germans onboard with the idea that if you want a single currency you have to accept that the strong must support the weak. I must admit I never appreciated how important fiscal and indeed political union is to a single currency zone. It is and until that bullet is bitten the crisis is with us for a long while yet.

More on this as the drama unfolds.