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Merry Christmas, Europe -- You've Been Downgraded

Merry Christmas, European Union.

Whether countries are willing to admit it or not, they take credit rating agencies seriously. Credit ratings measure confidence in a nation's ability to repay its debt. When the rating is lowered, it means the agency believes a nation is acting like a deadbeat. This, in turn, can affect a country's ability to borrow money; in theory, a lower credit rating translates into a higher interest rate, which is ultimately bad for the economy.

In August 2011, Standard & Poor's (S&P) downgraded the credit rating of the U.S. by one notch, from AAA (its highest rating) to AA+. A lot of political fingerpointing followed the decision. Republicans blamed President Obama's high levels of spending, while Democrats blamed Republicans' intransigence over raising the debt ceiling. In reality, both were to blame.

It is unlikely that any lessons were learned. The credit rating downgrade did not result in higher yields on U.S. Treasury bonds, making it mostly bark and no bite. Politicians and commentators, for their part, decided to attack the messenger: Perhaps S&P isn't as clever as they think they are.

Something similar is now playing out in Europe. On Friday, S&P downgraded the EU's credit rating from AAA to AA+. However, unlike in the U.S., the EU offers few bonds and is not allowed to run a deficit. Additionally, thanks to Germany, there are no joint Eurobonds whose interest rates could be influenced by a credit rating downgrade. So, S&P's announcement seems rather politically motivated, especially since it occurred just one day after an EU banking summit. The message is clear: S&P isn't confident in Europe's ability to clean up its own mess.

Predictably, EU officials fired back. Herman Van Rompuy, the president of the European Council, quipped, "The downgrade will not spoil our Christmas." Perhaps it shouldn't. In light of their failures prior to the 2007 financial crisis, credit rating agencies aren't held in nearly as high esteem as they once were.

Still, S&P's warning should not go unheeded. The EU should not be lulled into a false sense of security because its long-term health is still uncertain. That message is true, regardless of how imperfect the messenger.

(Photo: Alex Berezow)

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