Hamish McRae: America's fiscal position is even worse – will it lose its AAA rating?

Economic Life

Friday, 22 May 2009

Don't worry about Britain losing its AAA credit rating, but do worry about the rise in country debt here and indeed in pretty much every developed country in the world.

There is a cheap reply to the possibility that the UK may be downgraded following the "negative" outlook registered by the S&P ratings agency. It is that Lehman Brothers had a AAA rating until a few weeks before it collapsed. There is a slightly more thoughtful response which is to note that the reason for the negative outlook is that UK debt may reach 100 per cent of GDP unless we take action. But the fiscal position of the US looks even worse, for on present trends they may go well above that. So will it lose its AAA rating too?

Independent Graphics

• enlarge

Ratings still matter a bit despite the humiliation of the agencies, though I suspect they will matter less and less as investors will increasingly rely on their own research about the likelihood that debts will be met. And of course it is embarrassing. But the real significance will, I think, be that the markets will focus much more attention on the long-term fiscal position of different counties and charge a significant premium for political risk.

At the moment, country risk assessment is hopelessly crude. A couple of years back Ireland, Italy and Greece could borrow at almost the same cost as Germany. Now they have to pay much more. While the markets could be forgiven for missing the scale of Ireland's problems, the weak position of Greece and Italy should surely have been evident. Or to take another example, the US had "safe haven" status until recently, despite the inherent weaknesses in its fiscal position. Now that is just starting to be questioned – expect it to be questioned more and more.

So how will the UK's risk profile really stack up? The starting point of course is the level of national debt relative to GDP, which for the moment is quite low at below 50 per cent. But things can whistle out of control very fast and that is starting to happen, as yesterday's figures for the first month of the new fiscal year demonstrated. As you can see from the top two graphs, tax receipts are way below last year and spending way above. Last April receipts were £42.9bn; this year they were only £38.8bn. Current spending last year was £46.3bn; this year it was £48.8bn. So we are down £10bn on current spending on the month, and remember that under Gordon Brown's fiscal rule we would only borrow for investment. The current budget would be balanced over the economic cycle.

That leads into a discussion about sustainability. How quickly can the current budget be brought back to balance depends on what you think is happening to the economic cycle and to our long-term trend growth. The cycle we can pitch at eight-to-10 years: we cannot know precisely when the next peak of output will come, but let's say some time between 2017 and 2020. So, at some stage between then and now, we should be running a current budget surplus, as we did in the early years with Gordon Brown as Chancellor during the run up to the 2000 peak. Our problem was that he did not do so during the boom years in the run up to the 2008 peak.

That was a mistake partly out of hubris. Do you remember how he kept changing the calculation of the cycle to fit his figures? But there was also a genuine issue about the sustainable growth rate of the UK economy and in particular that during the boom years there is a natural tendency to over-estimate the long-term growth potential. You can see this is a stylised form (it does not refer to any particular country) in the next graph, taken from a paper by Stephen King of HSBC – and an Independent columnist on Mondays. The green line is the actual growth of GDP. During the boom, the shaded years, you think that the red line is your long-term growth path, when actually it is only the blue line. As a result fiscal projections are vastly over-optimistic. His conclusions are: "Fiscal austerity will place a huge constraint on any future recovery. The UK and US have the biggest problems. Fiscal frailties threaten currency crises, price instability and default."

Dire stuff. He is absolutely right to stress that this is a global problem and I suppose my own concern is that governments will not be able to make enough progress on getting their debts under control before the next downturn. So when that happens they will have no ammunition left to fire. It may seem a bit ridiculous to be worrying about the next downturn when we have not even begun to get out of this one.

Still, people are not stupid and if the past two years have taught us anything, it is that there is a strong economic cycle that we do not fully understand and certainly are not clever enough to eliminate.

We can, however, do some sums and the final graph shows some work by Goldman Sachs on the possible recovery profile for a number of developed countries. Here Goldman Sachs is looking at the trends in the economies rather than the trend in public finances, but it would follow that the quicker you can get the economy back to trend growth the better chance you have of getting public finances under control.

Australia is in the best position (followed actually by New Zealand, not shown). It went a little later into the cycle (blue blobs show the bottom); it should be back to its trend growth some time next year (red blobs); and by 2013 it will have made up the ground it has lost during the recession (green blobs).

The UK is not in quite as good a position, not returning to trend until the end of next year and not regaining lost ground until 2015. The US is in a worse position still and that of the big Continental nations don't bear thinking about. Japan is perhaps the most interesting, though. It gets back to its trend growth very soon. But it has lost so much output during the recession that it will be 2020 before it has got back to where it ought to be – that is assuming that the next downturn has not struck by then.

It is small comfort that Goldman thinks (and I am included to agree) that the UK is in not too bad a position in relative terms. The truth is that the entire developed world is in a mess. The task for our next Chancellor, which I suppose will be George Osborne, will be to get the finances back towards adequate shape before the next election in, say, 2014. That won't be enough time to fix things, for as Alistair Darling acknowledges, the fiscal position cannot be corrected in the life of one parliament. But a start has to be made, because if it isn't, it won't just be the loss of AAA status for Her Majesty's Government. It will be the sort of dire outcomes noted by HSBC above.

Jeremy Warner: What's the point of the rating agencies?

Friday, 22 May 2009

Outlook How dare they? Whatever the validity of the analysis, there are few things quite so guaranteed to get the juices of patriotic outrage flowing as the implied criticism of a threatened Standard & Poor's downgrade. Endless column inches have been expended in our national press criticising the Government for its disastrous mismanagement of the public finances, but now that an outside organisation has deigned to join the throng, that has really gone and done it. What do these people know?

What indeed, for Standard & Poor's is the very same agency that brought you triple-A rated "collateralised debt obligations", rock solid rated Icelandic banks, and singularly failed to predict either the banking crisis or any of the other financial and economic meltdowns of the past 20 years. It seems to be the lot of the credit rating agencies constantly to trail the reality, yet despite their failings, they have incredible power in markets. At their say so, corporations and governments fall and hundreds of billions are moved around the world, in often highly destructive asset reallocation, on their whim.

The tendency of rating agencies always to be behind the curve in their judgement of credit risk causes them to accentuate the boom and exaggerate the bust. In the upswing, they fail to sound alarms until it is too late and actively encourage it by assigning top-notch ratings to whatever innovations the financial markets throw at them. Then they make the downswing infinitely worse by rushing to catch up, thereby magnifying the panic.

Standard & Poor's latest research update on the UK, putting the nation on negative watch, is a risibly deficient piece of polemic which says nothing new and could almost literally have been written on the back of a fag packet. I'm not saying the analysis is wrong, but I am saying it is a poor show of scarcely any real value beyond a simplistic rehashing of the work already done much more effectively by the Institute for Fiscal Studies and the National Institute for Economic and Social Research. The few hard numbers it contains look from the outside to be largely guesswork. Yet its impact was dramatic, causing yields to soar, the pound to plunge and the stock market to bomb.

So S&P now thinks the Government debt burden could rise to 100 per cent of GDP and stay there "in the medium term". Well there's a surprise. Is this not what everyone has been saying since the Budget, and is it not also what is happening virtually all over the world. Credit risk is relative, and when mountains of government debt is being issued virtually everywhere, it scarcely seems to matter whose country it belongs to. They are all as risky as each other.

As for S&P's estimate of the costs of bailing out the banking system, this too at £100bn to £145bn (or 7-10 per cent of GDP), seems a figure plucked out of the air. For what it is worth, S&P gives the following explanation: "Our estimate of the potential gross upfront cost of the Government's financial sector support schemes takes into account our financial institutions team's assessments of the quality of the covered institutions loan book." Maybe S&P is right, but it seems equally likely, depending how the economy performs, that the support will end up costing the taxpayer nothing at all, or might even deliver a profit.

To be fair on S&P, it is obviously the case that the deterioration in UK public finances has been much more rapid than elsewhere, as evidenced by yesterday's borrowing figures for April. Political paralysis in the lead up to the election gives no cause to believe the problem is about to be adequately gripped. What is more, unlike the dollar, the pound is not a reserve currency, which means the propensity of foreign investors to lend, however bad the shape of the Government's books, cannot be relied apon in the same way as it can in the US and the core eurozone nations.

The perceived risks of default have quite plainly increased, even if in practice there is hardly any chance of it because in extremis the Government can just instruct the Bank of England to print more money so the debts can be honoured. This might result in a monumental inflation and currency risk, but they are not the same thing as risk of default. S&P seems to have no good answer to this contention either.

Not that Britain can be regarded as wholly reliable in honouring its debts. The traditional British method of defaulting is via the back door of inflating the debt away, but there has also been one case of outright default back in the 1930s when the government of the day cut the coupon on war loan. Even so, Britain has survived much higher levels of debt than are in prospect now without defaulting, most notably in the aftermath of the Second World War, when public debt as a proportion of national income was at well over 200 per cent.

Even if S&P enacted the downgrade, it may be of limited significance. Japan has lived with a rating of below triple-A for years now with no apparent difficulty in raising all the government debt it likes at extremely low interest rates. Despite the threatened downgrade – S&P says there is a one in three chance of it – yesterday's £5bn gilts auction by the debt management office was an encouraging 2.6 times subscribed.

A cynic would say it is easy to persuade investors to buy when the Bank of England's quantitative easing programme means the Government is shipping the stuff in through the back door as quickly as it is sold through the front. When that support goes, things might become tougher.

That point may be sooner than we think. The Bank doesn't intend to carry on buying assets indefinitely. Once the full £150bn of QE sanctioned by the Treasury is all spent, the Bank will at the very least pause for breath. Obviously it is not going to start selling the assets back while the Government is still funding 12 per cent deficits. Any tightening of policy will come first through interest rates. But in any case, there shouldn't be an outright crash. Even debt of 100 per cent of GDP is in theory fundable.

All the same, S&P's missive hardly helps. Both S&P and Moody's have in effect now said the rating is in danger unless a rather swifter fiscal consolidation is brought about than envisaged in the Budget. Nothing is going to happen for at least the next year, given the assumption that Gordon Brown will hang stubbornly on to the bitter end before calling an election.

No prime minister up for re-election is going to cut spending or raise taxes by more than he has already said, unless forced to by the markets. David Cameron has been less shy in warning about a period of considerable austerity to come to counter the profligacy of the past, but he has not said precisely how he is going to do it. Political honesty on such a scale is perhaps too much to expect.

Markets like certainty, but there is little chance of it in the next year. Instead, a period of political and public policy paralysis looms. This is perfect territory for rating agencies to wreak their usual havoc. As already mentioned, Japan survives without a triple-A rating, but then it has a current account surplus and deflation. There is no shortage of domestic savings to fund government borrowing.

A number of peripheral eurozone nations have had their ratings cut, but they are all free-riding off the single currency and the possibly misguided assumption that Germany will eventually bail them out. In fact, the Maastricht Treaty specifically disallows such bailouts so as to protect the purity of the currency. Given that these countries cannot print their own money to honour their debts, there is a real risk of default here. Even so, these nations are to some extent shielded by the euro.

Britain has no such protection. It can print its own money but is also highly dependent on foreign capital and therefore international confidence. We do not have the advantages of reserve currency status. If the rating agencies start misbehaving, there could be a problem. In their defence, the agencies have always insisted they are not in the business of prediction; rather, their purpose is to calculate using historic data, the probability of default and then assign a corresponding rating.

This methodology is fine until it goes wrong and there is a shock which interrupts historic trends. That is essentially what happened with the rating of mortgage debt, which has historically shown very low rates of default. But then mortgage lending was greatly expanded into sub-prime areas of the market and traditional models broke down.

Rating agencies are very bad when it comes to financial innovation. With new products, there is no historic data to guide them, so agencies take a cue from what they consider to be similar types of lending. This rarely proves instructive. Yet even when they have historic data, they still get it wrong. Sovereign debt is a case in point. History tells you that emerging market sovereign and banking debt tends to be suspect, yet the rating agencies foresaw neither the Latin American debt crisis of the early 1980s or the Asian financial crisis of the 1990s.

Rating agencies have become little more than creatures of the boom and bust of capital markets. Lemming- like, too many lenders have come to rely on their judgements. The banking crisis has highlighted afresh the need for root-and-branch reform of commonly applied systems of credit assessment. Investors and lenders might start by ignoring anything the big agencies say and conducting their own analysis. Nobody needs Standard & Poor's to tell us that Britain has problems; you would need to have been living on Planet Zog not to have noticed. But nor do we need the rating agencies to come stumbling in and provoke a flight of capital.