On Friday night the UK was given, for the first time in history, a downgrade of its credit rating, from AAA to AA1, announced by one of the rating agency oligopolists - Moody's. Here is their explanation:
"1. The continuing weakness in the UK's medium-term growth outlook, with a period of sluggish growth which Moody's now expects will extend into the second half of the decade;2. The challenges that subdued medium-term growth prospects pose to the government's fiscal consolidation programme, which will now extend well into the next parliament;3. And, as a consequence of the UK's high and rising debt burden, a deterioration in the shock-absorption capacity of the government's balance sheet, which is unlikely to reverse before 2016."
Two things should be taken into consideration regarding the rating downgrade. Firstly, we should be aware of the fact that before the crisis the rating agencies were giving AAA ratings to what later turned out to be junk bonds (everything from Greek debt to MBSs were considered to be a risk-free asset), thereby completely misinterpreting the market risk of such assets. However, this had more to do with the issue of the rating agency oligopoly position, their erroneous business model and false assumptions on certain assets and markets, but most importantly the artificial demand created for AAA-rated securities before the crisis (more on that here). Nevertheless they still do provide investors with some kind of reference point on the plausibility of a country’s economic policy to end the debt crisis
Second, this downgrade shouldn't be thought of as something inherently negative for the British economy. It will affect the government’s long term borrowing costs, but it won’t have a significant effect on households. It is by no means a signal for more fiscal stimulus (something that should be evident to any reader of Moody’s downgrade explanation). On the contrary, this should only create a stronger initiative for the British government to start with real structural reforms, and a proper way to conduct a fiscal consolidation.
Going back to Moody's conclusions, all these things stand. Britain does have unsustainable levels of government debt, medium-term growth prospects are terrible, and is close to repeating the woeful 1990s Japan approach.
Unfortunately, the Chancellor seems to have missed the message. He interpreted it only from one side of the coin: that Britain needs to persist in dealing with its debt. This is absolutely true. However, the other part of the coin implies the change of course of economic policy in Britain. Simultaneously decreasing the tax burden and the regulatory burden along with substantive reorganisation of the inefficient labour market to tackle declining British productivity, are good ways to start. In other words, using the Swedish approach as opposed to the Japanese approach (two countries that experienced a similar structural shock in the beginning of the 90s, but had very different responses and very different outcomes).
A rating downgrade for Britain shouldn't cause the same effect as it did in the US in 2011. However, in current times, it acts as a good signal of external enforcement to a government that seems to be missing more and more targets. It's a shame that it won't be interpreted as such, but that it will just go down as a reaffirmation of a faulty approach in a pointless political quarrel.