LONDON – Are panicked investors creating their own panic?

Rumors that France would follow the United States in losing its AAA credit rating, for instance, triggered a massive sell-off in Paris on Wednesday, with negative sentiment weighing on markets Thursday before a late rally. This week, investors have dumped French banking stocks in a frenzy of selling not seen since the height of the global financial crisis in 2008.

But there was one big problem. The downgrade rumor wasn’t true. The three major rating agencies all confirmed France’s AAA rating, adding that they had a “stable outlook” on French debt, with no immediate intentions of lowering it. Standard & Poor’s, the agency that downgraded U.S. Treasurys, went out of its way to stress its faith in politicians in Paris to compromise on a plan to reduce French debt.

As Giada Giani, a London-based economist with Citigroup, pointed out, S&P positively contrasted France “with the U.S., where it noted political parties are willing to sacrifice the sovereign’s top rating for political purposes.”

Of course, leading economists argue there is very good reason for the concern, if not outright alarm, that has sent markets into wild spasms and sparked fears of another global financial meltdown. Investors are simply waking up to a stark reality. Too many rich nations have vastly overspent, while failing to find a new path to robust growth.

That is particularly true in Europe, now at the core of investor concerns. There are mounting fears about the exposure of German and French banks to the troubled debt of Greece, Ireland and Portugal, as well as concerns about the massive economies of Italy and Spain. If things get worse in Italy and Spain, their bad debt could ripple through the global banking system, starting with Europe’s big banks, in the same manner that the collapse in U.S. subprime mortgage-backed securities did in 2008.

More basically, though, investors are responding to the failure of European leaders to find the political will to fully resolve the debt crisis that started in Greece and has spread over the past 22 months. Seventeen nations from Finland to Ireland have united in a common currency union, adopting the euro. But those nations have failed to link their economies together in a fiscal union that, for instance, would make German and Italian taxpayers as liable for the debts of the euro zone as Californians and Virginians are for U.S. debt. This has made investors, many argue, rightly nervous.

But European countries, notoriously bureaucratic and far from agreement on what to do, are unlikely to move fast to more fully link their economies. So, at the very least, investors are looking for an interim promise that European leaders are still refusing to make — that if things get worse in Italy and Spain, the financially stable nations including Germany and France will bail them out.

That has contributed to the current market fear that some argue is out of proportion to the immediate level of risk, and which has been sharply magnified by the credit-rating downgrade and worries of a slowdown in the United States.

The spread of panic to France might motivate Europe to respond faster to calm a cycle of panic that, rightly or wrongly, has now become the dominant psychology of the market.

“My view on France is that there are problems in the banking cycle, there are problems with how the whole sovereign debt crisis is being dealt with in Europe, and the market is showing nervousness and concern regarding the end game,” said Laurent Moulin, an economist with Geneva-based Lombard Odier Investment Managers. But “I think right now we have kind of an exaggeration. I don’t think the French banking system is going to go bankrupt,” he said.

Analysts note that the concerns about French and German banks holding the bonds of Italy and Spain are based on fears that those bonds will dramatically drop in value. Yet that would happen only if investors themselves lose faith in those bonds, dumping them in accelerated panicked selling.

“Part of the problem is that countries like Italy haven’t really had a sympathetic hearing from the markets,” said Stephen King, chief economist with HSBC Bank in London. “If you look at some the smaller periphery countries in trouble in Europe, they behaved rather badly in the past. But Italy is a very different story.”

He added: “Although you can say that Italian debt is high, it’s been high for a while, and nobody has been worried about it. They’ve actually had, and have, a conservative fiscal policy.”

But in the current climate, investors don’t want to hear excuses; they want action. For example, they want nations such as Italy to front-load budget cuts even if that means contributing to the very economic slowdown that investors fear.

“Part of the problem is that market reality is partly made by the self-fulfilling prophecy,” King said. “If you didn’t have stock market crashes, you wouldn’t have the kind of economic causalities that follow.”

 

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