Saturday, 23 February 2013

Running Out of Rope

It is easy to dismiss the downgrading of the UK’s credit rating by Moody’s as yet another example of an agency stating the blindingly obvious. Indeed, so belated are such judgements that a Bloomberg report notes that bond markets ignore more than half of the agencies’ decisions on sovereign ratings.[1] Moody’s decision is an embarrassment for the UK Chancellor, oleaginous Osborne, as he promised to retain the coveted AAA status. It could also be a soundbite benefit for the opposition, but for the fact that their spokesmen cannot even pronounce the words ‘credit rating’ correctly. However, the significance of the decision is that it shows how the UK is running out of options to manage the crisis and that a more aggressive policy is likely.

Moody’s cited two related problems that result in a third: weak economic growth and high debt levels mean that the UK government is in a much worse position to manage further ‘shocks’.[2] Hence the downgrade. Moody’s assessment is that stagnant growth will hinder the reduction of the UK government debt, which it now expects will reach a level of 96% of GDP in 2016. This figure is high, but it would have been higher still had it not included the Treasury allocating to itself a surplus of some £35bn from the Bank of England’s emergency operations, and if it did not exclude the liabilities from the so-called ‘temporary’ financial interventions after 2007!

These latter items are extraordinary. The £35bn is the accumulated net interest from buying gilts that the Bank of England has gained from the Quantitative Easing programme. It has purchased a huge amount of government debt (£375bn) with monetary financing, got paid interest on the debt by the Treasury and then gave the interest back to the Treasury. This is a form of debt monetisation, one that is moderated only by the Bank of England buying debt in the secondary market and under a specific programme, rather than being open-ended, direct government financing by the central bank. As for the financial interventions to save the banking system, the ultimate scale of the liabilities is unclear, but, taking the cases of Lloyds and RBS, the UK government spent £66bn on their shares in a quasi-takeover. On the latest count it remains under water to the tune of £14bn just on the RBS holdings.

Moody’s analysis focuses on government debt because it is rating the UK government’s credit. However, it is well aware of the extreme levels of debt in the whole UK economy, levels that have also alarmed the Bank of England and underpin the widespread forecasts of stagnation. Some 280 people are declared bankrupt or insolvent every day in the UK, according to Credit Action data, while outstanding personal debt is close to the value of GDP and average debt per UK adult is £29,000, or 117% of average earnings.

The explosion of debt is a function both of the 2007-08 financial sector slump, and of the longer-term dependence of growth on credit expansion. Now the limits have been hit, more or less. This is the most important implication of the credit downgrade decision. Far from Moody’s assessment being an attack on government austerity policy, or endorsing more government spending to rescue the economy, as Labour party commentators like to imply, the agency makes very clear that a further credit downgrade would be in prospect if

“government policies were unable to stabilise and begin to ease the UK's debt burden during the multi-year fiscal consolidation programme. Moody's could also downgrade the UK's government debt rating further in the event of an additional material deterioration in the country's economic prospects or reduced political commitment to fiscal consolidation.”

The ratings change will likely have little effect on UK bond yields, at least in the immediate period. It is only a one-notch downgrade from the top rating by one agency, and similar downgrades of the US in 2011 and France in 2012 had no measurable impact – one that would indeed be difficult to measure, given the extraordinary crisis policies followed by all central banks. Furthermore, Moody’s points out that the UK is in a robust position in its debt financing, given its freedom in monetary policy and the relatively long maturity of its outstanding debt. So, the end is not nigh yet.

Neither is any abrupt UK policy change likely to follow from Moody’s downgrade. Instead, the background default policy remains as before: a remorseless squeeze on living standards. In the five years to early 2013, average weekly earnings rose by 9%, but retail prices (RPI measure) rose by 17.2%, resulting in a fall of 7% in real earnings. More of the same is in prospect, with a variety of price hikes in the pipeline and little effective resistance from workers.[3]

However, this squeeze is showing no sign of recreating conditions for renewed economic growth. This is not because austerity curbs demand, as Keynesians like to argue, but because conditions for profitable accumulation remain stubbornly absent. Boosting ‘demand’ through more government spending would only make the debt dynamics worse, yet limits on spending have obviously done little to encourage investment. By the third quarter of 2012, the volume of business investment had recovered somewhat from the trough of 2009, but it remained 8% lower than at the beginning of 2008. At the end of 2012, the GDP measure of output was still more than 3% below its level four years earlier. Official interest rates are the lowest on record, both in the UK and elsewhere, but the rates at which companies can borrow do not make investment attractive. Stagnation persists.

A striking fact is that while there have been many reports of cuts in government spending, and plans for more cuts in future years, the latest data to January 2013 show no reduction in central government spending on social benefits or other expenditure (outside debt interest). Nominal spending has risen roughly in line with inflation.[4] This suggests that the complaints over ‘cuts’ are more about the cuts that are in prospect, while the real austerity is yet to come.

With a desperate economic situation at home, it was no wonder that Prime Minister Cameron recently took the largest ever delegation of companies, more than 100, to India to tout for business. The main items up for sale were British military hardware, and Cameron extolled the virtues of the Eurofighter jet, partly built in Britain, over the decision India looks already to have made, to buy 126 French-made Rafale fighters in a multi-billion dollar deal. Aside from exports, Cameron also represented the interests of British companies that wanted to invest directly in the Indian domestic market, one that looks more promising than Europe in coming years.

Another policy that is ripe for conflict with other struggling powers concerns the exchange rate of sterling. Over recent months the Bank of England has continued to endorse a fall in the value of sterling on the foreign exchanges to ‘rebalance’ the economy. Since mid-December, sterling’s value has slumped by close to 7% versus both the euro and the US dollar. That will do little to boost exports in a world economy where output growth remains weak and where many other countries also toy with devaluation policies. However it is another point of tension, to complement the debates over Europe’s proposed financial transactions tax and other populist initiatives.

Tony Norfield, 23 February 2013

[1] Fergal O’Brien, ‘UK Loses Top Aaa Rating From Moody’s as Growth Weakens’, Bloomberg News 22 February 2013.
[2] “Moody's believes that the mounting debt levels in a low-growth environment have impaired the sovereign's ability to contain and quickly reverse the impact of adverse economic or financial shocks. For example, given the pace of deficit and debt reduction that Moody's has observed since 2010, there is a risk that the UK government may not be able to reverse the debt trajectory before the next economic shock or cyclical downturn in the economy.” The UK report is on their website:
[3] Note that the Bank of England’s monetary policy committee is not bothered about ‘above target’ inflation when real earnings are falling and the rate of inflation has not (yet) become too embarrassing. This is especially when they are in no position to raise interest rates to curb inflation, as the old policy stance would have it, because of the still disastrous levels of debt.
[4] Total current central government expenditure rose by 6.3% year-on-year in January 2013, and for the period from April to January, the rise was 3.6%. ONS, Public Sector Finances, January 2013, Table PSF3A.