On the surface, it looks simple: Independent experts issue reports that a debtor's ability to repay his debt has diminished. This because of overspending and lower income (in this case tax revenue). As a consequence of this, the borrower must pay a higher interest on his loans. This is roughly what has happened to Spain and Greece in recent days. The three (US-based) global rating agencies have issued reports or warnings that these two countries represent an increased default risk.
There is, however, a lot more to this story than meets the eye. Firstly, the stories about reduced ratings are a detriment to the Euro. The main beneficiary is the dollar. Having the world's undisputed reserve currency has over the years given USA a considerable advantage, as the quickly growing world trade required an increasing number of dollars for trade purposes. This role has been increasingly questioned as the Euro has proven stable. Several large development countries have openly talked about using euro for trading and currency management purposes. A healthy dose of euro unrest could stop such initiatives dead in their track.
Secondly, the world is emerging from a deep economic crisis triggered by irresponsible banking practices. Whereas the logical (and comparatively cheap) solution would have been to temporarily nationalise the banks, fire the management, rebuild their balance sheets and, in due time, to reprivatise the banks, no governments chose this avenue. The governments did not have the stomach to take on the banks, which, despite being deadly injured, were allowed to continue roughly as before. Instead governments threw tons of (future tax payer) money at the banks.
The effect was to turn what should have been a balance sheet issue into a strongly negative cash flow for the public sector. In the medium term, the effect is worse, as the refinancing of the banks anyway have caused the public sector balance sheets to deteriorate sharply. So the end effect was anyway to replace the unhealthy bank balance sheets with an unhealthy public sector balance sheet. On top of that the banks reacted by cutting credits, which negatively influenced the economic growth. This could partly have been counteracted by a Swedish-1990's-style intervention.
What the governments could have done differently is uninteresting now, except that we can learn how not to do it next time. The fact is that in order to avoid a collapse of the banking sector under the weight of its own greed and incompetence, the governments HAD to accept a certain erosion of its financial situation. Since a well-functioning banking system is necessity in a modern economy, the governments simply had no choice.
Of course some countries had public sector finances already in a not-so-good shape and Greece is certainly one of them. One thing is that the current public deficit is about 12 percent of GDP. Quite another thing is that its existing debt already stood at approximately 100 per cent of GDP at the end of 2008. This combination does not call for a lot of confidence.
If I had been a conspiracy theorist I would have added a third point: The deterioration of the government finances is nothing new, nothing surprising, and nothing that the rating agencies have not known about for quite a while. So my point would have been that the timing of the downgrades or warnings has a curious coincidence with the apparent attempts from the US political establishment to talk the dollar out of the weakening trend we have seen for most of 2009. And that this timing could form the basis for next round of the battle for having the dominant reserve currency. It obviously would not be nice of me to suggest anything like that.
The loud support for Greece from Germany could indicate that this whole story is not only about what we see on the surface. There are much bigger interests involved, namely the future of the status of the euro.