Tuesday, 14 February 2012

Moody's downgrade: both Osborne and Balls get it wrong


The reaction of politicians to Moody's decision to put the UK's AAA rating on "negative outlook" was predictable - and predictably tendentious.  The Chancellor described it as "proof that, in the current global situation, Britain cannot waver from dealing with its debts" while the Shadow Chancellor said it was a "significant warning."

They are both wrong. It proves nothing and signifies less.  The misdeeds and incompetence of the credit ratings agencies in the run-up to the financial crisis has been well documented. What is less well understood is that when it comes to rating sovereign debt, they simply do not know what they are talking about; worse than that, they do not even understand what their own credit ratings mean.


Moody's says its ratings are "opinions of relative credit risk of financial obligations...they address the possibility that a financial obligation will not be honored as promised."  Standard and Poor's has much the same definition.  So when it comes to rating UK government bonds, what the ratings agencies are assessing is simply the probability that the UK government does not pay back, in pounds, the money it has borrowed.  Pounds which can be - and as we have seen over the past two years, have been, even in far less extreme circumstances  than a potential default - created at the push of a button by the Bank of England.

The implication is obvious.  In the event of nuclear war or an asteroid strike, it is possible the UK government might not pay its debts.   Then we'll have other things to worry about. Otherwise, it will, simply because it can -  and because the consequences of not doing so are dreadful.  So whatever else happens, holders of gilts will get their money back. Saying that there is any meaningful probability that the UK will default on its debt - which is what downgrading the UK means - is not to take a particular view on the UK economic or fiscal outlook. It is simply not to understand what you are talking about.

So what, in fact, do Moody's think they are saying?   Some commentators try to make excuses for the rating agencies, saying that, despite their official definitions,  what they really mean is that people should be worried about putting their money in gilts, because inflation and interest rates might be higher in future, which would reduce the value of any gilts bought now.   And indeed gilts investors should rationally take these factors into account.

But if this is in fact the argument, then Moody's have got the economics completely the wrong way round. Their statement says that the main rationale for the downgrade is the "weaker macroeconomic environment".   But in fact, as we have seen in spades over the last year, a weaker macroeconomic environment is good for gilts.  Markets correctly anticipate that if growth is going to be weak, interest rates will stay low for a long time - pushing long-term rates down, and pushing gilt prices up. 

Suppose you had read our forecasts, gloomy but not gloomy enough, a year ago, and anticipated that the macroeconomic environment would indeed be much weaker than the government (or Moody's) predicted.  Would the right thing to do have been to buy gilts or sell them? By Moody's logic, the latter. Of course, that would have been an exceptionally costly mistake. .

We could of course ask Moody's what they mean or think they mean.  Last month, Sarah Carlson, Moody's UK analyst, was quoted in the FT as saying "We talk about countries having altitude in the triple A ratings space."  No,  I don't have a clue what she's talking about either. 
The final argument made by those who think we should pay attention to the rating agencies is that they may be incompetent and their judgements meaningless - but the markets listen.  For example, the Guardian today (I single them out because they really should know better) said:  

"The AAA rating is the highest awarded to a country and allows it to borrow at the lowest interest rates"
However, as far as countries which can create their own currency are concerned, this just isn't true. As we saw recently, the market's response to Standard and Poor's downgrading of the US was to buy Treasury bonds and push down long-term interest rates.  And this reaction isn't new or temporary. The chart below shows long-term interest rates in Japan since the late 1980s.   Over that period, Japan has experienced a "weak macroeconomic environoment", to put it mildly, which inspired Moody's and the other ratings agencies to downgrade it several times. In fact Moody's first downgraded Japan in 1998. 


Now Japan's economic policy over that period has hardly been a success. But the market and credibility impact of successive downgrades has not exactly shaken market confidence in Japan's debts;  Japan is now paying the lowest long-term interest rates in recorded economic history (dating back to the Babylonian Empire, in fact).  

So how should the government, and the markets, respond to the rating agencies?  The former should, and the latter in my view will, simply ignore them.  The Treasury should stop obsessing about how they will react, stop inviting them in for presentations and discussions about the economic and fiscal outlook, and simply say "We couldn't care less what the ratings agencies say. The UK will pay its debts. We have a credible and sustainable fiscal policy and we will continue to do so."   Meanwhile, the Shadow  Chancellor should make his arguments for an alternative approach to fiscal policy on the merits of the case, not attempt to bolster them by appealing to the judgement of these discredited and irrelevant organisations. 

I still think the government's fiscal policy is wrong.  In the short term fiscal policy is too tight; the resulting unnecessarily high levels of unemployment will do long term social and economic damage.  A temporary loosening of policy would improve prospects for output and employment with little or no negative effect on fiscal credibility; the benefits, in my mind, substantially outweigh the hugely exaggerated market risks.  But what the ratings agencies say, either in the past or in the future, is not a vindication either of my arguments or the government's; those need to be settled on the basis of proper economic analysis, not the misleading and ill-thought out views of Moody's and their ilk.

[This is an updated version of my Independent column here, last month]. 


Addendum:  For anyone who needs further convincing of the irrelevance of the ratings agencies, see Olaf Storbeck's blog here [HT the excellent Chris Dillow], reporting on a new, rigorous econometric study which concludes:  “The informational value of credit ratings is surprisingly low” (I'd quarrel only with the word "surprisingly").  In fact, the researchers' own very simple model easily outperforms the agencies.  


8 comments:

  1. I agree, but the politicians are playing Average Joe and Jane on the street and trying to score political points.

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  2. Though I actually I agree with much of what you say, I can see a (their?) rationale over the long term:

    Short term - gilts are the best place for your money.

    Long term - the government is going to be saddled with a whole lot of debt. As a result it may enter a debt trap or inflate its debts away. In either of those cases you may not get back everything you put in. That doesn't stop it being the best deal now, but it's worth bearing in mind.

    I suspect the markets have decided that it's still the best thing out there. But the agencies aren't there to predict what the markets will judge, just to predict what will happen to an investment.

    I'm also not sure that relying on the markets' judgement to prove rating agencies wrong is the strongest argument. The market may judge things will go on fine for a long while but, if there is to be a correction, it will probably be a sharp one.

    That's me being my charitable best to the agencies. If I were the government or the markets I would take your advice. Gilts, even though they may have some risk, are still one of the safest bets at the moment. And the agencies do have a terrible record, even if there is a rationale behind their judgement.

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  3. It's only significance is the political significance Osborne gave it, using as a stick with which to beat the oppositon.

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  4. Great analysis Jonathan, this is spot on: "The Treasury should stop obsessing about how they will react, stop inviting them in for presentations and discussions about the economic and fiscal outlook, and simply say "We couldn't care less what the ratings agencies say. The UK will pay its debts. We have a credible and sustainable fiscal policy and we will continue to do so.""

    http://thegoldenlatrine.blogspot.com/2012/02/does-it-matter-if-britain-loses-its.html

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  5. Don't fall for the idea that future tax revenue is required to pay off government debt. In fact, it is a myth that taxes "pay" for any government spending.

    When an economy is at 'full capacity', (i.e. very low unemployment and all resources in the economy being used productively), a government may wish to spend say £20Bn on something everyone agrees is needed - it could be repaying govt debt, defending the country, building hospitals, whatever. When it spends this money it inevitably causes inflation - this is because you have more spending chasing the same amount of goods and services. The amount of goods and services does not change because the economy is already at full capacity.

    To enable the government to spend without causing an inflationary spiral, the government taxes by an equal amount to prevent the private sector spending by the same amount - so overall the spending (public and private) remains roughly constant, so no inflationary spiral.

    So the extra tax is to prevent an inflationary spiral when the economy is at full capacity - it is not required to "finance" govt spending. This is why government economics is nothing like household economics.

    However, when an economy is the position ours is in with excess capacity, spending by government is permissible without taxation as it doesn't cause inflation.

    Given that our economy has not been at full capacity for over 30 years (hence the high unemployment), the government does not need to increase taxes or cut spending elsewhere to "pay" the interest on govt debt or to "pay" for anything.

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  6. The big question is why does the government issue bonds at all and pay interest to private investors? Why doesn't the government just create the money at the mint or Bank of England - this won't be inflationary as there is spare capacity.

    An answer often given is that when governments issue bonds someone has to surrender money to the government. If it wasn't for the bond that money would probably have gone into the banking system instead. This is called a 'reserve drain' and was clearly necessary when we had the Gold Standard/Bretton Woods or some other type of Fixed Exchange Mechanism.

    The argument given now is that debt is a better way to stimulate the economy. Supposedly there is a problem with a liquidity trap in the banking system. By issuing bonds the government can take money away from the banking system and make sure that it is being spent.

    However, it's pretty obvious that for countries with their own floating currency, deleveraging banks and with economies working at way, way below spare capacity that you can use QE to clear government debt at will without any inflationary effects.

    This is obviously in the UK since there is £275 billion sitting in the Asset Purchase Facility. This money was bought using reserve crediting in 2010/11 and the result of the purchases was deflationary - M4 last year after £200 billion of QE had hit stall speed with growth at only 2% (more than 5% growth is needed to prevent the economy contracting).

    So we are left with a ridiculous situation where the Tories are moaning about the huge and "unaffordable" government credit card bills. At the same time over a third of the debt they are moaning about is stuck in the government owned Bank of England with no hope of it ever being anything other than cancelled and retired. To add to the hilarity the Treasury, through a wholly government owned agency called the Debt Management Office pays interest on the £200 billion in the APF to the wholly government owned APF. This money is just building up and will eventually (as all profits for the Bank are) be returned to the taxpayer.
    You couldn't make this up.

    So clearly in economic circumstances such as now you can print money directly, buy outstanding government debt and retire it with no inflationary consequences. Nevertheless Governments are continuing to use an explanation built up at a time of Bretton Woods with full employment, fixed exchange rates and no deleveraging to explain why they don't use the QE to clear down debts.

    The question I would ask Jonathan is why the Treasury has persisted with the fairy tale that gilts should be used to fund deficit spending?

    Is it a "political" issue or is it a hidden subsidy to pension funds or something else?

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  7. Are you saying that sovereign debt of every country that has its own currency should be AAA? So, china, indiia, and every other developing country should also have highest possible rating because they can always print more. The historical experience says that even countries that have their own currency can default often times not because they can't print money but because they don't want to for various reason. Search Moody's website for a paper published on this topic. The lead author is Elena Duggar.

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