Credit ratings agencies are in the doghouse in Brussels, both for their supposed role in making the financial market crisis worse than it need have been, and for their alleged failure thereafter to put their houses quickly enough in order.

But that isn’t deterring the agencies from taking a hard look at the way Europe’s recession is straining the public finances of certain governments in and out of the euro area.

Last week, Standard & Poor’s, one of the world’s three main agencies, warned that it might cut the sovereign debt ratings of Greece and Ireland. In truth, that wasn’t really a surprise. The crash of the Irish “Celtic tiger” economy is no secret. As for Greece, a study by the Citigroup economist Jürgen Michels last month contained the alarming prediction that Greece’s public debt would soar to 108.5 per cent of gross domestic product in 2010 from 94.8 per cent in 2007.

S&P delivered a bigger shock on Monday when it said it might also cut the sovereign debt ratings of Spain, the eurozone’s fourth largest economy. The reaction in the markets said it all. The spread between Spain’s 10-year government bond yields and those of Germany rose to its highest level since 1999, when the euro was launched. The same fate befell government bonds in Portugal, which investors seem to think is next on the list for a possible downgrade.

Of course, threatening a downgrade is not the same as putting the threat into effect, and it’s possible S&P won’t take the second step. Moreover, Moody’s, another big agency, tends to be more cautious before contemplating a change to a government’s credit standing.

But the message from the agencies, and from financial markets more generally, is clear. A spending spree to get out of Europe’s recession will carry penalties, even if it is accompanied by promises of a rapid return to fiscal rectitude once the worst of the crisis is over.

Spain is, in fact, better placed than many other EU countries to run up higher budget deficits and take on more debt. During its long spell of strong economic growth, Spain took care to maintain a budget surplus, and its public debt at the end of 2007 was only 36.2 per cent of GDP, according to Eurostat, the EU’s statistical agency.

But for other countries - Greece and Italy come to mind - it’s a different story. And that explains why there is a lot more nervousness in EU capitals than is commonly appreciated about the wisdom of large-scale deficit spending to end the recession.

January 13, 2009 10:05am in Financial crisis | Comment