Tuesday, 26 February 2013

CPS: "Credit downgrade - misinterpreting the signals"

I wrote a new text for the Centre for Policy Studies, commenting Britain's credit rating downgrade. For all my other CPS writings see here


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.

4 comments:

  1. Im not sure how will it affect long term borrowing costs, I guess the effect will be more apparent after this crisis passes.

    My guess is you have a good insight into british economy, so I wanted to ask you what you think of the (robust) british labour market in face of pretty lackluster growth last few years?

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    1. Funny, but I also wrote a text about this a few months ago - here it is. Basically, the problem they are facing is declining productivity (obviously). And the reason for this, in my opinion, could be the government job policies. "While the British government is going head over heels to try and bring more people into work, their programs of incentivising employers to hire more workers is an example of a severe labour market distortion. No wonder productivity is rapidly falling. Employers hire people only to get the government benefit. There is no economic incentive for an employer, apart from the government subsidy he receives. The additional worker won’t create new value; his or her marginal product is very likely to be diminishing. So what’s the point of the policy? Simple, it shows good numbers and thus relaxes the pressure off the government. The fact is that this is just another ‘Potemkin village’ designed to skew the public opinion into showing that the government is actually doing something to help the economy. But here’s the catch – whatever it does, it only hurts the chances of recovery."

      Also, when you look at their employment-population ratio, the labour market is not as robust as it seems (which would imply a lot of people pushing themselves out of the labour force all together).

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    2. Thnank you! You have to give them credit, they succeeded where a lot of governments have failed - forgetting the adverse side effects, the measure had results they wished for. Problem is that "ceteris paribus" didnt play along lol. Now everyone blames "austerity" for the slow growth instead blaming failures of not doing meaningful reforms...typical.

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    3. Exactly, the problem is always that "ceteris paribus didn't play along".

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