Britain has been downgraded. So what?
On Friday night Moody’s finally took the decision to downgrade Britain’s credit rating for the first time since the 1970’s. It sent out the warning that ‘despite considerable structural economic strengths, the UK’s economic growth will remain sluggish over the next few years due to the anticipated slow growth of the global economy and the drag on the UK economy’. On Saturday morning the world continued as normal; the markets will have undoubtably priced in the change already, commentators of the less hysterical kind were unsurprised and many intimated that the only thing the rating of AAA had stood for was the sound that economists made when they commented upon Britain’s economic situation.
Despite all the uproar (the Daily Mail was horrified that this gave Britain the same credit rating as France) there is nothing to suggest that this would have any major effect on the British economy or the government’s fiscal position. The pound has fallen a little but it had done so in the days preceding the announcement. The other large economies that were downgraded from AAA experienced few negative ramifications.
When the USA was downgraded in August 2011 by Standard and Poor’s, it caused a short term panic because a major economy had never been downgraded; the Dow Jones and Nasdaq both fell over 6% the day after. Yet investors still flocked to US government bonds as they continued to see them as a safe bet in a time of volatility. The only noticeable outcome was a drop off in net foreign investment in long term bonds, but these had been falling anyway. As time passed the rating downgrade had no long term effect about the desirability of US debt.
Nor did it really have any effect on the US economy or the actions of the government. The downgrade was attributed to the lack of progress dealing with the country’s debt problem, and the ‘difficulty of bridging the gulf between political parties over fiscal policy.’ This has not changed, as the fractious fiscal cliff talks which ended by simply postponing the big decisions demonstrated.
When France lost its AAA credit rating, this time due to the country’s well noted lack of competitiveness, there was again little change. The more paranoid took it as confirmation that the Anglo-American conspiracy against the French way of economics ran even deeper than the bastion of liberal ideas that is ‘the Economist’, but the cut did not impact upon French bond yields. On this occasion there was less panic, as the shock impact of a ratings downgrade had faded.
This feeds into the idea that credit rating adjustments are less significant than they used to be. On most occasions, they simply seem to confirm what financial markets and analysts have already noted. Furthermore, numerous downgrades in a short period have dulled their impact. Yet it also stems from the reduced credibility that these agencies have following the financial crisis. In its aftermath the two fundamental problems of the credit rating agencies were exposed. One was that many of their mathematical models that calculated risk were useless. Another was that the issuer of the debt or a financial product paid the agencies for a rating, incentivising them to be lenient, as otherwise the firm choose another agency to make the calculation. The result was that 64 000 products were given AAA ratings. After the house prices began to fall many of them were downgraded to junk status. Moody’s downgraded 83 percent of the $869 billion in mortgage securities it had rated at the AAA level in 2006.
It appears that sovereign credit ratings seem increasingly irrelevant and largely symbolic, but that does not mean that there are not serious problems with the British economy. It reinforces that the spotlight has now largely shifted from the size of a country’s deficit to its prospects for growth. Last year, when Standard and Poor’s downgraded 9 European countries in one fell swoop, it suggested ‘We believe that a reform process based on a pillar of austerity risks becoming self-defeating, as domestic demand falls in line with consumers’ rising concerns about job security and disposable incomes, eroding national tax revenues’.
The Chancellor’s austerity plan seems increasingly unsuited to the economic conditions of the moment. When it was put into action, the idea was (relatively) simple. Britain’s borrowing costs would fall through increasing economic credibility by taking action quicker than its competitors, meaning it could become a ‘safe haven’ for investors. Such actions would help safeguard Britain’s credit rating, which he viewed as fundamental to curbing borrowing costs.
This judgement was wrong. The factors cited earlier explain the lack of significance in a credit rating. Furthermore, the Chancellor seemed not to realise that the reasons behind the financial markets’ faith in a country are very volatile. At the start of his time in power the reasons for confidence in a country switched back and forth between deficit size and growth prospects. Now it is mostly about the latter.
These growth prospects are being strangled by austerity measures. George Osbourne suggested that the measures would not negatively impact upon the UK economy as investment and exports could drive growth.
He believed that investment would be aided by the low interest rate and the rising confidence caused by rectifying the public finances and reducing the inefficiency in the public sector. This idea fell away because the Chancellor seemingly failed to take into account that this was a recession caused by a collapse in the financial system resulting in a liquidity trap. The ensuing dysfunctional banking system, excessive debt held by firms and individuals and historically low confidence meant that investment could not take off. Exports suffered because the same thing was happening in export markets, and the Eurozone crisis compounded in these countries.
In order to justify austerity examples were given of when this approach has been successful. However, these had all been during times when the world economy was booming. No country can cut effectively if everyone is pursuing the same policy. In this respect the effect of the fiscal multiplier was underestimated, and a recent report by the IMF suggested as much.
It was already clear that Britain is in trouble before the rating change. However, the president of YouGov, Peter Kellner suggested one effect of the cut is that it could be a ‘blame changer’, shifting the public’s perception of who is responsible for Britain’s economic situation from Labour to the Conservatives. More importantly from an economic perspective, its effect is likely to be negligible.