We expect modern governments to help us when we're down. For Canadians, this takes the form of (un)employment insurance, pensions for the elderly and disabled, universal health insurance and more. This social safety net works because the country at large pitches in through taxes, while only those in trouble - historically spoken of as 'the deserving' - get the payouts.
One big question is, who are the deserving? At first blush, it may seem obvious that we have to narrow eligibility for benefits to those who are really down on their luck. Consider old age pensions. Surely it's silly to give government pensions to the rich as well as the poor. The rich, being wealthy, don't need the typically small allowance and will probably just blow it on caviar and designer hubcaps. The poor, on the other hand, actually need the money to buy basic necessities, like bread, beer and heating fuel. Besides, if we give money to the rich, there's that much less to give to the poor.
Thoughts along these lines have led to the means testing of a host of benefits. Before the government hands out any cash, they check to make sure that you're miserable enough to qualify.
This all seems very reasonable, unless you've had some training in economics. Economists are trained to look beneath the surface of choices involving scarce resources, and the more you look at means testing using econo-vision, the more rotten it appears. It turns out that in many situations (including old age pensions) giving money to everyone trumps giving money to the deserving poor.
Below are the top five reasons why means testing is often a bad idea.
5. Stigma
Consider the following scenario. You've worked for twenty years at a bowling alley, but in 2008 the global recession comes along and you're laid off. People living through a world-wide financial crisis and credit crunch are worried about the future and not willing to spend much of their money on luxuries such as bowling. Or restaurant food. Or manicures. Pretty much everyone is firing their workers and hiring less, so you have to settle for working two entry-level part-time jobs in order to make ends meet. You used to live comfortably, but now you're stretching a package of Kraft Dinner for three meals and think washing laundry with soap is something that happens to other people. The baby's getting skinny, the roof is leaking and the car has all its battle scars from recent bumps and crashes. Time to ask the government for help, right?
Only if you're willing to endure the soul-crushing erosion of your sense of self-worth. Researchers recently confirmed what a bunch of us already suspected: many poor people will avoid going on the dole because they don't want to officially be tagged as paupers, and don't want government bean-counters to sneer at them while scrutinizing their income and expenses. The first might seem odd - if you're poor, you're poor, and there shouldn't be any problem with being correctly classified. There shouldn't be, but there is. It's the difference between showing up at the grocery store cashier station with an almost-empty cart and paying for it in cash, and showing up with a full cart, but paying for it with food stamps (or these days, a food ATM card). In the first case, you're poor, but proud - you may not be able to buy much with your income, but what you decide to do with it is entirely up to you. In the second case, your method of payment shows everyone staring at you in the grocery store that the government believes you can't be trusted with real money, and need to be stopped from spending your allowance on lottery tickets, booze and porn.
Something similar happens even when you're actually receiving a cheque that can be turned into cash. Cashing that welfare cheque can feel like advertising that you've failed at life, and aren't able to make it on your own without a government bailout. Interestingly, this effect is in play even when we're looking at big banks instead of poor people. When the US government insisted on handing out bailout money to banks, many of them tried to refuse the offered money. They were worried it would make them look bad in the eyes of their depositors and shareholders. Even the banks that were at risk of going bankrupt in a day or two didn't want to take the bailout money unless more prosperous banks took it, too. They didn't want to stand out as the ones that couldn't make it without a crutch from Uncle Sam.
Finally, there's the second form of stigma pointed out in the research paper. The thing about means testing is that in order for you to receive a benefit, someone (a government employee) has to go through the details of your life to make sure you're poor enough to qualify. This process can be humiliating and demeaning. "Oh, I see you have a pet fish, Mr. Smith. You told me you didn't have enough money to feed yourself, but you have enough to feed a pet?" "Do your children actually NEED a new sweater every year?" "Why does your cupboard have name brand cereals instead of the no name ones? Why do you have something as decadent as a cupboard at all?"
All these problems go away when the benefit is universal and everyone is getting it. There's no more shame in cashing that cheque because the millionaire up the road got one, too. If the family with the SUV is using food stamps to pay for a few frivolous desserts, it doesn't look bad when you use yours to buy the majority of your groceries. Also, if everyone is getting a cheque just for being alive and a resident, there's no longer any need for government agents to perform an audit almost as personal and pleasant as a colonoscopy.
Speaking of those government agents...
4. Means testing costs money
Gathering detailed information about people isn't cheap. Neither is processing information once you have it. Means-testing benefits like pensions is a continuing process - every month (or however long it is between payments) the government has to make sure that benefit recipients don't become wealthy enough to disqualify them.
Governments around the world are in financial trouble right now. Even setting aside debt-fueled meltdowns such as those in Greece and Portugal, their costs are up. No one's buying stuff, which means no one is hiring workers to make stuff, and on top of that banks are getting very shy about lending money to anyone. All this means that claims on (un)employment insurance and welfare are rising, at the very same time that the government's own income (tax revenue) is falling. Politicians are scrambling for ways to make national ends meet. One of the very first suggestions to come up is usually tighter means testing. The idea is that if you disqualify anyone who is able to afford two meals a day and give money only to the very poorest, you'll have more money to spend on bank bailouts and election advertising.
There are many problems with that notion, but here's one of the biggest: going down that route will massively increase the costs of administering the benefit. Remember, these countries are going through bad times so there are more people than usual applying for government benefits. This means that the country will need more civil servants to process the applications, which is costly. Tightening means-testing will require more investigation and monitoring of individuals, which also raises costs.
In the end, just giving the benefit to everybody who is breathing and a resident may be cheaper than hiring an army of men in suits to check monthly whether applicants are sufficiently close to starvation to merit a break. This is especially true if the benefits in question are tiny, as in fact the most heavily means-tested benefits tend to be.
Even worse - in a heavily means-tested world, where you may be disqualified for government aid if a civil servant notices you've graveled your previously dirt driveway, there's temptation on both sides for the applicant to slip a bill to the auditor to make her look the other way. That brings us to our next point:
3. Means-testing encourages fraud and corruption
Sadly, this one is self-explanatory - or should be. If an applicant's success in receiving government money depends on what a civil servant writes on her clipboard, there's temptation on both sides for the applicant to bribe the civil servant in exchange for approval. This is especially true if the means-testing is difficult or uncomfortable to qualify for. The bribe can potentially be quite high as a percentage of the benefit, since as far as the applicant is concerned, getting any money at all is better than not qualifying.
The more complicated the qualifications are, and the more people are applying, the easier it is to get away with fraud. Hey! What a coincidence - those are exactly the two conditions that we see being fulfilled in recession-ravaged countries. Given that governments usually implement means-testing as a way of saving money, there's not enough cash to hire more auditors to check on the civil servants and double-check their paperwork. The only way to detect fraud of this sort is if someone slips up in an exceptionally foolish way. Maybe a civil servant whose job it is to process applications for pensions suddenly starts wearing a Rolex watch and is caught speeding on the highway in a Porsche with a very expensive escort at his side. Or perhaps a welfare recipient shows up to the bank to cash the cheque in a designer suit, with diamond rings on every finger and a smile with enough gold teeth to plate a teacup. Unlike these show-offs, any fraudsters who play it safe and keep their heads down can remain undetected indefinitely.
Getting your citizens to treat bribery and fraud as a part of everyday life is a bad thing. Unfortunately, the harsher means testing is, the more it encourages this. No one wants to have to get rid of their decadent glass windows and working refrigerator in order to qualify for $40 a month, but if you can slip a tenner to an interviewer to have them confirm that you live in a shack made of cardboard salvaged from other shacks, why not?
Giving the benefit to everyone eliminates the middleman, and with it the temptation or possibility of fraud. (Well, okay, you can still pretend that your deceased friend is alive and continue to cash their welfare cheques.) It's not a good idea to make fraud part of the national culture, so governments may want to avoid creating a situation tailor-made for it. The harsher the means test is - the more miserable you have to be to qualify - the more likely it is that people will find ways to cheat.
2. Complexity means less take-up
The more tightly a government means-tests, the more questions it has to ask applicants and the more forms that must be filled out. In some cases, getting a benefit may involve visits to different government agencies, or having to fill out complicated questionnaires and provide evidence of destitution every month.
At some point, potential applicants may decide it's just not worth the hassle. Or they may be confused by a long list of requirements and decide not to bother since they probably don't qualify, even if they do.
Assuming the government is not actively searching for those who qualify for benefits (that'd be costly), means-testing can lead to those who need and qualify for the benefit not receiving it. By trying to exclude the well-off from the benefit recipients, you may end up excluding the poor, as well. This is doubly the case in countries where the poor have a low rate of literacy, and therefore have trouble wading through piles of government documents. A related problem is that the very poor may not have required supporting documents stating their identity and socioeconomic status. In this case, only the wealthiest of the poor, those who are already plugged into the system to a large degree, will be able to qualify for the benefit. The neediest will be excluded.
All of this can be avoided by having the benefit be universal. Proof of life and proof of residence are all that is needed. These are easily understandable and easily obtained.
At last we come to the 800-pound gorilla in the room...
1. Means testing is a tax that rewards poverty and discourages work
Suppose you've managed to jump through all the hurdles and are the proud recipient of a basic income grant, employment insurance, a child credit and government-paid medical insurance. All of this is given to you by your society's safety net because a year or two ago you fell into hard times. You lost your job, had to pay for an expensive operation, and ended up selling your house and moving into a trailer.
You've been happy to rely on government money while you piece your life back together, but now that you're in a better situation you figure it's time to get back to a career and re-join working society.
You've been out of the job market for a while, so it's unlikely employers will hire you for a rewarding full-time job right away. You need to start small, maybe working part-time at a retailer to build up much-needed work experience. So, you look in the classifieds, find a few promising ads, and are about to apply for them... when you realize that taking the jobs would make you poorer than you are now.
Why? Because all your benefits are means-tested. When you take on a part-time job and start earning a very small income, your basic income grant will be reduced dollar for dollar of your earnings. You'll be working for free. All of a sudden, nights spent frying potato chips and spreading mustard on hamburger buns don't look as attractive as an evening in front of the television - and that's not all. Since you're employed, employment insurance will also vanish. Having a reasonable if tiny income also makes you too wealthy to receive government health insurance or the child credit, so now you have to pay for operations (part of what landed you in poverty in the first place) and your child's clothes and school supplies on your own. You'd better hope you stay healthy despite your poverty-induced high fat, low nutrient diet, and that your child stops growing until clothes go on sale at the consignment store.
All in all, it's better to stay unemployed, since trying to bring yourself out of poverty will only make you poorer. Means testing is a tax on work, and a high one.
My example is extreme and crafted to exaggerate a point, but a very readable paper agrees with the basic message. The authors calculate that in real-world Canada, means testing works out to an effective 45% tax rate on each additional dollar earned for families with children that earn $20,000 to $30,000 a year. This tax rate isn't reached by families without children until they have an income of $70,000 a year. This is about twice the average Canadian income. The reason for the difference? Child benefits are clawed back from the moment a family starts earning an income that keeps them from starving. Every dollar earned means a fraction of a dollar lost in benefits. When an extra dollar earned means 45 cents lost in benefits, sacrificing a family's quality time to go from part-time work to full-time work or developing a higher-paying skilled career doesn't look very attractive. Means testing discourages the poor from taking on the jobs that could eventually take them out of poverty. The short-term cost is just too high.
"Stay poor, and we'll help out - if you manage to make it through all the bureaucratic hurdles. Try to get out of poverty, and we'll pull the rug out from under you." That's the basic message of means-testing. Targeting benefits to the poorest makes work very expensive. If benefits are universal, we don't see this disincentive to participating in the job market. If flipping burgers at McDonald's doesn't cost you your child grant, and you're able to keep all or most of what you make, you're more likely to take that fast food job, and maybe use it as a springboard for a more valuable career later on.
Means testing is one of those obvious notions that is actually a pretty crummy idea when you look at it closely. Unfortunately, its common sense appeal makes it very popular. Nearly every government in the world uses it as a linchpin of its social welfare program, and in the current global recession many nations are looking to tighten their welfare requirements. Instead, they should be loosening them.
Friday, January 20, 2012
Sunday, January 15, 2012
Grain prices in 2012
The price of grain has risen dramatically the last few years. This matters a lot because the world's poor subsist largely on grain. Any increase in price means less calories per day, malnutrition and starvation. Emerging economies, where standards of living are rising quickly, are also hard hit. As a population becomes more prosperous, it demands more meat in its diet. All those cows and chickens eat grain - a lot of it - and so a rise in the price in grain translates to a rise in the price of meat.
With that in mind, at first I was happy to read that according to the Food and Agriculture organization of the United Nations (FAO), food prices started falling in the latter half of 2011. Sure, the food price index for 2011 was still the highest since the FAO started measuring it in 1990, but at least there seemed to be hope for the future.
Reading past the headline tempered my enthusiasm. As an economist, I should have known that the price of something will generally fall for one of two reasons (or a combination of the two): lower demand, or higher supply. If no one wants something, the seller of the good will have to lower its price if she plans to get rid of it. If the market is flooded with more of a good than people wish to buy, its price will fall as sellers scramble to be the lucky one that gets a sale.
Both of these have happened in the global grain market. Worldwide financial troubles, particularly in Europe, have lowered demand for grain. Workers in Greece, say, are worried not only about their own jobs and incomes, but about their government's ability to continue to provide basic services. Frightened about the future, they've cut down on spending. Not just spending on luxuries and treats, but spending on basic food (grains and meat). That's scary.
Meanwhile, a bunch of farmers around the world looked at record grain prices from 2008 to 2010 and decided they wanted a piece of the action. Fields that might have grown other crops were converted to grow rice, wheat and (to a lesser extent) corn, and now there's too much of the stuff. Thankfully, grain can be stored, but that does nothing for farmers who need to sell their harvest NOW in order to have the money to feed their family and continue farming.
This happened dramatically in the US states of Kansas, Oklahoma and Texas. There, three things combined to make farmers plant more wheat than they ever had before. First, a drought that had been making it difficult to grow anything in the region eased. Second, the drought had led to many failed crops, and now those fields were ripe for planting with winter wheat. Finally, the high price of wheat made planting it seem a winning proposition. The problem is, of course, that it's not just one farmer thinking this way - they all did, and since they couldn't coordinate with each other, too much wheat was planted. The price of the grain fell so far that at least one farmer believes he can make more money selling his wheat crop as hay than as a grain.
Speaking of farmers coordinating with each other... the Canadian Wheat Board is set to lose its monopoly of western Canadian wheat in August of 2012. Until then, if you farm wheat in western Canada, you must sell it to the Wheat Board, which uses its clout (20% of the world's export market for wheat) to negotiate high prices. The Board isn't being entirely dismantled, but participation will be optional from August onward. Some farmers will choose to negotiate their own deals with wheat buyers. Since individual farmers have less bargaining power than the monolithic Wheat Board, and since the Board itself will have less wheat to bargain with, this should lead to lower prices for wheat worldwide. It may also lead to less planting of wheat in Canada, since the reward for doing so may fall.
Now for rice. The big players in the rice export business are India, Thailand and Vietnam. Right now, India is beating its competitors on price. This is despite an increase in domestic Indian demand for rice after the New Year's holidays, and an increase in the price of Indian rice to anyone buying it in US dollars, due to a newly strong rupee. In Vietnam's case, the price of its rice is higher than India's due to a government-instituted price floor on rice. In an attempt to help rice farmers, rice cannot be sold for less than the floor price. Unfortunately, this floor price is higher than the price of Indian rice, which makes Vietnamese rice relatively unattractive for importers. (This is just one of many cases where price-fixing worsens the problem it was intended to solve.)
India's strong performance on the world rice market is a little surprising, given how recently it came to the party. For four years, India banned the export of rice. The ban was only lifted last year, and so far India has exported 1.2 million tonnes of rice. An enthusiastic take-up of rice exporting is set to lead to a bumper crop this year, which will add to India's already large stockpiles of rice.
That up there is an important thing to remember, by the way: even if you are a grain exporter, you should not forget to keep stockpiles of the grain at home, just in case. South Africa has learned this lesson the hard way. Last year, it had a huge surplus of maize. Much more was harvested than South Africans could possibly eat in a year. As a result, most of it was exported. And by 'most of it', I mean almost all of it. Grain silos were left nearly empty. This left South Africa unprepared for this year's disappointing crop. (It's not in the article, but it may be that the huge surplus lowered maize prices to the point where farmers switched to other crops, leading to a shortage this year.) Not enough maize was grown to feed the country (or its chickens - poultry producers are upset at the rise in the price of feed), and South Africa found itself having to import maize at 800 rand a ton. It had exported its maize at 600 rand a ton. I wouldn't be surprised if it turned out that it was buying its own grain back...
So there you have it. Grain prices in 2012 are likely to go down, both due to excess supply from farmers that wanted in on the action of 2011's high prices, and from depressingly low demand in the European Union and elsewhere.
With that in mind, at first I was happy to read that according to the Food and Agriculture organization of the United Nations (FAO), food prices started falling in the latter half of 2011. Sure, the food price index for 2011 was still the highest since the FAO started measuring it in 1990, but at least there seemed to be hope for the future.
Reading past the headline tempered my enthusiasm. As an economist, I should have known that the price of something will generally fall for one of two reasons (or a combination of the two): lower demand, or higher supply. If no one wants something, the seller of the good will have to lower its price if she plans to get rid of it. If the market is flooded with more of a good than people wish to buy, its price will fall as sellers scramble to be the lucky one that gets a sale.
Both of these have happened in the global grain market. Worldwide financial troubles, particularly in Europe, have lowered demand for grain. Workers in Greece, say, are worried not only about their own jobs and incomes, but about their government's ability to continue to provide basic services. Frightened about the future, they've cut down on spending. Not just spending on luxuries and treats, but spending on basic food (grains and meat). That's scary.
Meanwhile, a bunch of farmers around the world looked at record grain prices from 2008 to 2010 and decided they wanted a piece of the action. Fields that might have grown other crops were converted to grow rice, wheat and (to a lesser extent) corn, and now there's too much of the stuff. Thankfully, grain can be stored, but that does nothing for farmers who need to sell their harvest NOW in order to have the money to feed their family and continue farming.
This happened dramatically in the US states of Kansas, Oklahoma and Texas. There, three things combined to make farmers plant more wheat than they ever had before. First, a drought that had been making it difficult to grow anything in the region eased. Second, the drought had led to many failed crops, and now those fields were ripe for planting with winter wheat. Finally, the high price of wheat made planting it seem a winning proposition. The problem is, of course, that it's not just one farmer thinking this way - they all did, and since they couldn't coordinate with each other, too much wheat was planted. The price of the grain fell so far that at least one farmer believes he can make more money selling his wheat crop as hay than as a grain.
Speaking of farmers coordinating with each other... the Canadian Wheat Board is set to lose its monopoly of western Canadian wheat in August of 2012. Until then, if you farm wheat in western Canada, you must sell it to the Wheat Board, which uses its clout (20% of the world's export market for wheat) to negotiate high prices. The Board isn't being entirely dismantled, but participation will be optional from August onward. Some farmers will choose to negotiate their own deals with wheat buyers. Since individual farmers have less bargaining power than the monolithic Wheat Board, and since the Board itself will have less wheat to bargain with, this should lead to lower prices for wheat worldwide. It may also lead to less planting of wheat in Canada, since the reward for doing so may fall.
Now for rice. The big players in the rice export business are India, Thailand and Vietnam. Right now, India is beating its competitors on price. This is despite an increase in domestic Indian demand for rice after the New Year's holidays, and an increase in the price of Indian rice to anyone buying it in US dollars, due to a newly strong rupee. In Vietnam's case, the price of its rice is higher than India's due to a government-instituted price floor on rice. In an attempt to help rice farmers, rice cannot be sold for less than the floor price. Unfortunately, this floor price is higher than the price of Indian rice, which makes Vietnamese rice relatively unattractive for importers. (This is just one of many cases where price-fixing worsens the problem it was intended to solve.)
India's strong performance on the world rice market is a little surprising, given how recently it came to the party. For four years, India banned the export of rice. The ban was only lifted last year, and so far India has exported 1.2 million tonnes of rice. An enthusiastic take-up of rice exporting is set to lead to a bumper crop this year, which will add to India's already large stockpiles of rice.
That up there is an important thing to remember, by the way: even if you are a grain exporter, you should not forget to keep stockpiles of the grain at home, just in case. South Africa has learned this lesson the hard way. Last year, it had a huge surplus of maize. Much more was harvested than South Africans could possibly eat in a year. As a result, most of it was exported. And by 'most of it', I mean almost all of it. Grain silos were left nearly empty. This left South Africa unprepared for this year's disappointing crop. (It's not in the article, but it may be that the huge surplus lowered maize prices to the point where farmers switched to other crops, leading to a shortage this year.) Not enough maize was grown to feed the country (or its chickens - poultry producers are upset at the rise in the price of feed), and South Africa found itself having to import maize at 800 rand a ton. It had exported its maize at 600 rand a ton. I wouldn't be surprised if it turned out that it was buying its own grain back...
So there you have it. Grain prices in 2012 are likely to go down, both due to excess supply from farmers that wanted in on the action of 2011's high prices, and from depressingly low demand in the European Union and elsewhere.
Saturday, January 14, 2012
Do downgrades matter?
The big economic news in the past few days has been Standard & Poor's downgrading of the credit rating of a number of European countries. France and Austria went from AAA to AA+, while Portugal's credit rating fell to the level commonly described as 'junk'.
Why does this matter? For more reasons than you'd expect.
Let's start with the most direct effect: when choosing where to put their money, investors use credit ratings as a guide. The ratings are an estimate of risk put together by analysts and researchers at a ratings agency, such as Standard & Poor's. A country with a AAA credit rating is almost certain to pay back a loan. A country with a much lower CCC rating has a good chance of not paying back, or 'defaulting', on a loan.
The whole reason investors are willing to lend money to countries is that they'll be paid interest in addition to the principal once the loan is due. How much interest an investor will demand from a borrower depends largely on the perceived risk of the loan: the reward must be proportional to the risk. It doesn't take much for an investor to be willing to lend to someone with a AAA credit rating: they're almost certain to be paid back, and any interest is basically free money. (Or if you like, compensation for not having had access to the lent money for the duration of the loan.) Countries with a AAA rating can therefore borrow at very low interest rates. If a country has a low credit rating, investors will demand a high interest rate if they're to lend it money. If they're going to gamble, the jackpot needs to be worth it.
A numerical example: suppose an investor is considering lending 10 dollars to Jack and Jill. Jill has a flawless credit rating, and the investor only asks for $1 in interest. When Jill pays him back, he'll have $11. Now suppose Jack's credit rating is so low that he has a 50% chance of going bankrupt before he can pay back the loan. How much interest does the investor need to charge so that on average he'll get the same return as he did lending to Jill? Half the time, Jack won't pay him back at all, so he'll get $0. Half the time, Jack will pay him back with interest, and the investor will get $10 + X, where X is the interest. On average, then, the investor will be paid ($10 + X)/2. To make this equal to $11, X needs to be $12. For the investor to be willing to lend to Jack when he can always lend to Jill instead, Jack must pay at least 12 times the interest Jill pays.
There, then, we have the first effect of a credit rating downgrade: the affected countries will have to pay more to borrow money. This is a very bad thing, since most of the countries involved are heavily in debt, and in a recession. During a recession, governments have all sorts of extra costs, from increased welfare and employment insurance payments to bailouts for banks. Having to pay more for loans makes it difficult to meet these responsibilities.
Countries with low credit ratings can lose out completely on some of the biggest investors, such as pension funds. Many of these funds have rules against investing in an asset below a certain credit rating. According to Wikipedia, the top 300 pension funds hold over $6 trillion (US) in assets, so that's a lot of money that's not available to countries like Portugal, with very low ratings.
An aside: for countries with their own currencies, paying their debts are not a problem, as long as the debts are denominated (that is, written in) the local currency. All the government needs to do is print enough money to cover the bill. This is not without consequences, of course. Just like flooding the market with apples lowers the price of apples, flooding the market with, say, pesos, will reduce the value of those pesos (i.e. what they can be traded for), and the country will experience inflation. The debts will be paid, though. In practice, many debts are written in terms of a foreign currency (usually U.S. dollars), or have clauses in the fine print that makes the face value of the debt go up with inflation. Countries in the euro zone face the additional problem of sharing a currency. Greece and Germany have the same currency, the euro, but while Greece would love to print more euros, prosperous Germany would be against it.
The credit downgrade of European countries can also affect European banks. This is the main mechanism by which the rating change will affect everyday citizens and businesses.
Banks run on confidence. Their job is to take money from depositors and lend it to borrowers, at interest. Any money that's sitting in the bank vault is not earning interest, and so under usual circumstances banks keep as little cash as possible on hand. If too many depositors ask for their money back at once, the bank will collapse, since most of the money is tied up in loans that take time to call in. It's the depositors' confidence that the bank is a safe place to keep their cash when they're not using it that keeps the banks going.
One of the reasons depositors have confidence in banks is that they know (or expect) that the banks are guaranteed by the government. If a bank starts to fail, the government will step in with deposit insurance or a bailout. However... if the government itself has a low credit rating and people believe it has difficulty paying its debts, they may also worry about its ability to bail out a bank. A downgrade in the credit rating of a country can therefore land that country's banks in trouble. Depositors may start pulling out, and the banks will have to pay more interest when they borrow, since they're now seen as riskier.
It's very common for banks to misjudge how much money they needed to keep in their vaults on a given day. Thankfully, there's a flourishing overnight loan market. If on a particular day a bank finds itself short of cash, they can borrow it from a bank that found it had extra cash at the end of the day. If all the banks are short of cash, then they borrow from the central bank, the lender of last resort. In most countries, the central bank can always print more money, so it's always able to provide a loan.
Starting this summer, a large number of European banks found themselves short of cash at the same time. Since they couldn't borrow from each other, they turned to the bond market. (A bond is basically a printed I.O.U. promising to pay the money back with interest at a given date.) No one was interested in buying their debt, and the banks found they had to turn to the European Central Bank (ECB) for their cash.
At first, the ECB offered to lend them money for one year at reasonable interest rates. The banks declined, saying that it would take them more than a year to collect payment from the borrowers they intended to lend the money to. That is, the ECB bill would come due before their own paycheques arrived.
In late December, the ECB repeated the offer, this time with a 3-year loan. Takeup was enthusiastic. Note that these ARE loans, not free money. Just like a regular person buying a house uses the house as collateral for the mortgage, the banks had to use whatever assets they had as collateral for their loans from the ECB. The ECB would accept the collateral at less than face value. Let's say a bank had an office building worth $100,000. The ECB might accept it for $80,000 of collateral.
Many of the assets the banks offered the ECB took the form of euro-zone bonds: IOUs issued by the governments of the euro area. When these countries received a credit downgrade, all of a sudden their debt was worth less. A 10-dollar IOU that said 'I'll pay you back $11 in three years' now was worth less than $11 due to the increased chance that the country would default on the debt (i.e. would not pay it). The amount that the ECB was willing to lend to the holders of these bonds fell with the value of the collateral.
European banks don't trust each other to pay back loans, either. Bank-to-bank lending has largely dried up, as indeed has lending to individuals and businesses. Instead of lending out the money they borrowed from the ECB, banks are putting it right back into their central bank savings accounts (central banks are the banks' banks). This is kind of silly, because the ECB charges 1.75% on its loans, and only pays 0.2% on its deposits.
To be fair, the European Banking Authority has recently asked banks to increase their capital. The banks have had to call in loans, sell off assets, retain earnings (not pay dividends to shareholders) and convert bonds into shares despite bond-holders' protests. (Whoever, in the comments, manages to explain how this bond to share conversion raises bank capital wins a prize.)
So, there you have it. This is why one agency's downgrading of European sovereign credit ratings matters. It makes it more expensive and more difficult for those countries to borrow at a time when they could really use credit, it lowers confidence in banks due to the reduced chance of a bailout and it lowers the value of existing European bonds, which can play a part in making banks less willing to lend and less able to borrow from the ECB's emergency fund.
If you're still confused or still interested, here are a few articles I found helpful in putting together this post:
Banks in Europe scrape together the extra capital they need
The ECB fills banks with funds
Why the eurozone downgrades matter
Eurozone's Friday the 13th
Which are the eurozone's zombie banks?
Why does this matter? For more reasons than you'd expect.
Let's start with the most direct effect: when choosing where to put their money, investors use credit ratings as a guide. The ratings are an estimate of risk put together by analysts and researchers at a ratings agency, such as Standard & Poor's. A country with a AAA credit rating is almost certain to pay back a loan. A country with a much lower CCC rating has a good chance of not paying back, or 'defaulting', on a loan.
The whole reason investors are willing to lend money to countries is that they'll be paid interest in addition to the principal once the loan is due. How much interest an investor will demand from a borrower depends largely on the perceived risk of the loan: the reward must be proportional to the risk. It doesn't take much for an investor to be willing to lend to someone with a AAA credit rating: they're almost certain to be paid back, and any interest is basically free money. (Or if you like, compensation for not having had access to the lent money for the duration of the loan.) Countries with a AAA rating can therefore borrow at very low interest rates. If a country has a low credit rating, investors will demand a high interest rate if they're to lend it money. If they're going to gamble, the jackpot needs to be worth it.
A numerical example: suppose an investor is considering lending 10 dollars to Jack and Jill. Jill has a flawless credit rating, and the investor only asks for $1 in interest. When Jill pays him back, he'll have $11. Now suppose Jack's credit rating is so low that he has a 50% chance of going bankrupt before he can pay back the loan. How much interest does the investor need to charge so that on average he'll get the same return as he did lending to Jill? Half the time, Jack won't pay him back at all, so he'll get $0. Half the time, Jack will pay him back with interest, and the investor will get $10 + X, where X is the interest. On average, then, the investor will be paid ($10 + X)/2. To make this equal to $11, X needs to be $12. For the investor to be willing to lend to Jack when he can always lend to Jill instead, Jack must pay at least 12 times the interest Jill pays.
There, then, we have the first effect of a credit rating downgrade: the affected countries will have to pay more to borrow money. This is a very bad thing, since most of the countries involved are heavily in debt, and in a recession. During a recession, governments have all sorts of extra costs, from increased welfare and employment insurance payments to bailouts for banks. Having to pay more for loans makes it difficult to meet these responsibilities.
Countries with low credit ratings can lose out completely on some of the biggest investors, such as pension funds. Many of these funds have rules against investing in an asset below a certain credit rating. According to Wikipedia, the top 300 pension funds hold over $6 trillion (US) in assets, so that's a lot of money that's not available to countries like Portugal, with very low ratings.
An aside: for countries with their own currencies, paying their debts are not a problem, as long as the debts are denominated (that is, written in) the local currency. All the government needs to do is print enough money to cover the bill. This is not without consequences, of course. Just like flooding the market with apples lowers the price of apples, flooding the market with, say, pesos, will reduce the value of those pesos (i.e. what they can be traded for), and the country will experience inflation. The debts will be paid, though. In practice, many debts are written in terms of a foreign currency (usually U.S. dollars), or have clauses in the fine print that makes the face value of the debt go up with inflation. Countries in the euro zone face the additional problem of sharing a currency. Greece and Germany have the same currency, the euro, but while Greece would love to print more euros, prosperous Germany would be against it.
The credit downgrade of European countries can also affect European banks. This is the main mechanism by which the rating change will affect everyday citizens and businesses.
Banks run on confidence. Their job is to take money from depositors and lend it to borrowers, at interest. Any money that's sitting in the bank vault is not earning interest, and so under usual circumstances banks keep as little cash as possible on hand. If too many depositors ask for their money back at once, the bank will collapse, since most of the money is tied up in loans that take time to call in. It's the depositors' confidence that the bank is a safe place to keep their cash when they're not using it that keeps the banks going.
One of the reasons depositors have confidence in banks is that they know (or expect) that the banks are guaranteed by the government. If a bank starts to fail, the government will step in with deposit insurance or a bailout. However... if the government itself has a low credit rating and people believe it has difficulty paying its debts, they may also worry about its ability to bail out a bank. A downgrade in the credit rating of a country can therefore land that country's banks in trouble. Depositors may start pulling out, and the banks will have to pay more interest when they borrow, since they're now seen as riskier.
It's very common for banks to misjudge how much money they needed to keep in their vaults on a given day. Thankfully, there's a flourishing overnight loan market. If on a particular day a bank finds itself short of cash, they can borrow it from a bank that found it had extra cash at the end of the day. If all the banks are short of cash, then they borrow from the central bank, the lender of last resort. In most countries, the central bank can always print more money, so it's always able to provide a loan.
Starting this summer, a large number of European banks found themselves short of cash at the same time. Since they couldn't borrow from each other, they turned to the bond market. (A bond is basically a printed I.O.U. promising to pay the money back with interest at a given date.) No one was interested in buying their debt, and the banks found they had to turn to the European Central Bank (ECB) for their cash.
At first, the ECB offered to lend them money for one year at reasonable interest rates. The banks declined, saying that it would take them more than a year to collect payment from the borrowers they intended to lend the money to. That is, the ECB bill would come due before their own paycheques arrived.
In late December, the ECB repeated the offer, this time with a 3-year loan. Takeup was enthusiastic. Note that these ARE loans, not free money. Just like a regular person buying a house uses the house as collateral for the mortgage, the banks had to use whatever assets they had as collateral for their loans from the ECB. The ECB would accept the collateral at less than face value. Let's say a bank had an office building worth $100,000. The ECB might accept it for $80,000 of collateral.
Many of the assets the banks offered the ECB took the form of euro-zone bonds: IOUs issued by the governments of the euro area. When these countries received a credit downgrade, all of a sudden their debt was worth less. A 10-dollar IOU that said 'I'll pay you back $11 in three years' now was worth less than $11 due to the increased chance that the country would default on the debt (i.e. would not pay it). The amount that the ECB was willing to lend to the holders of these bonds fell with the value of the collateral.
European banks don't trust each other to pay back loans, either. Bank-to-bank lending has largely dried up, as indeed has lending to individuals and businesses. Instead of lending out the money they borrowed from the ECB, banks are putting it right back into their central bank savings accounts (central banks are the banks' banks). This is kind of silly, because the ECB charges 1.75% on its loans, and only pays 0.2% on its deposits.
To be fair, the European Banking Authority has recently asked banks to increase their capital. The banks have had to call in loans, sell off assets, retain earnings (not pay dividends to shareholders) and convert bonds into shares despite bond-holders' protests. (Whoever, in the comments, manages to explain how this bond to share conversion raises bank capital wins a prize.)
So, there you have it. This is why one agency's downgrading of European sovereign credit ratings matters. It makes it more expensive and more difficult for those countries to borrow at a time when they could really use credit, it lowers confidence in banks due to the reduced chance of a bailout and it lowers the value of existing European bonds, which can play a part in making banks less willing to lend and less able to borrow from the ECB's emergency fund.
If you're still confused or still interested, here are a few articles I found helpful in putting together this post:
Banks in Europe scrape together the extra capital they need
The ECB fills banks with funds
Why the eurozone downgrades matter
Eurozone's Friday the 13th
Which are the eurozone's zombie banks?
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