Moody's has threatened to downgrade the UK. It could be the first step on a horrible journey...
RATINGS AGENCY Moody's has changed its outlook for the UK to negative, meaning it could lose its Aaa rating. If it follows through on its warning, a UK downgrade could be the start of something much worse, writes Ben Traynor at BullionVault.
The next crisis to hit Britain's shores could see two things happen:
- Investors become reluctant to buy UK government debt, sending borrowing rates higher, as has happened to several Eurozone countries
- The British government gains control of the levers of quantitative easing, with the chancellor making the final decision over whether or not to directly finance government borrowing in an effort to lower those borrowing costs
As any student of economic history knows, central bank monetization of government debt is a terrible idea. It is the first step towards hyperinflation, as Zimbabwe, Hungary and Weimar Germany have all demonstrated.
We are still some way from that happening in Britain. Hopefully it never will. But the warning from Moody's reminds us that it could.
Moody's says it expects UK government debt-to-GDP to peak in 2014 or 2015 at 95%, though it says this is both later and higher than most other triple-A rated sovereigns. As always with ratings announcements, there are caveats. It depends on growth not weakening too much (Moody's expects the UK to get back to trend growth of 2.5% a year, which may come to look a tad optimistic).
The markets of course are also key. If the UK government's borrowing rates shoot up, this would obviously change the calculus regarding the level of debt that is sustainable.
This shot across the bow from Moody's should see the UK government speed up its austerity program in the hope of warding off a sovereign debt crisis. Indeed, in many ways it is music to the government's ears, since it confirms the wisdom of a path it is already (purportedly) on. Chancellor George Osborne described the Moody's announcement as "a reality check for anyone who thinks Britain can duck confronting its debts".
"We can't waver in the path of dealing with our debts," Osborne told BBC Radio 4.
"Here is yet another organization warning Britain that if we spend or borrow too much we are going to lose our credit rating but, more importantly, what that leads to potentially is a loss of investor confidence in our economy."
Needless to say, the government will face continued opposition to cuts in spending. Critics will argue, as they already are, that cutting too rapidly will itself harm growth prospects, and could potentially exacerbate rather than improve the fragile situation.
The worst case scenario for Britain could be that the government fails to head off a sovereign debt crisis despite pressing ahead with austerity measures, and so finds its policies blamed for the ensuing chaos. This would diminish the appetite for further reform amongst politicians and the public as a whole – exactly what is happening in Greece right now.
Furthermore, the markets (and ratings agencies) will recognize this, meaning the UK would have a tough time getting its borrowing rates back down again once a loss of confidence had sent them higher.
Of course, the UK does have one advantage that Greece and other Euro members don't: monetary sovereignty. In extremis, the UK authorities can settle any Sterling denominated debts by simply creating new currency with which to pay them. It can also lower government borrowing costs by bidding up the price of Gilts with the state, in effect, lending to itself.
Thanks to quantitative easing, the tools are already in place that enable the Bank to buy government-issued Gilts with newly-created money. So far the Bank has bought assets to the tune of £273.5 billion, the vast bulk of which have been...UK government Gilts. So far these have been bought from financial institutions rather than from the government directly (though it must surely support demand for Gilt issues if buyers feel there is a willing buyer for those assets who has limitlessly-deep pockets, or indeed if that institution is happy to lend against Gilts at favorable rates).
So far, so de rigeur – at least by post-2007 standards. But the warning from Moody's ratchets up the pressure. And an actual downgrade would crank it up even more.
Britain's current government does not have to call a general election for another three years. As that date approaches, though, and as any further cuts start to bite, the scope for cutting more should it look like missing its deficit reduction targets will diminish. Electoral concerns, if nothing else, are liable to stay the hand of any chancellor contemplating deeply unpopular action. Again, investors would recognize this, weakening private demand for Gilts.
Backed into a corner, political leaders would be keen for an easy way out. In such a situation, what would they give for the power to pump up Gilt demand via QE, rather than hoping the Bank of England does it.
This is not an idle concern. A shift in power from central bankers to politicians is underway. A report published last November by HM Treasury, 'Accountability of the Bank of England', stresses the need for the Bank to be more transparent. The government is openly fretting about new powers the Bank of England is getting which will make it responsible for "preventing another financial crisis".
All well and good, you may think. But there is a trade-off between transparency and independence. For all its flaws, an independent Bank of England does, at least in theory, represent an obstacle to direct monetization of British government debt. Certainly it is hard to imagine a serving chancellor faced with a budget crisis being less likely to take that option.
The Bank's response to the Treasury's report acknowledges that there should be "a power for the chancellor, when public funds are at risk and there is a serious threat to financial stability, to direct the use of the Bank's tools of crisis management."
Could those tools include financing government budget deficits? Quite possibly. In practice one imagines this being wholly justified by those in charge, as "crisis management" sees government spending soar, the bond markets take fright, and the need to avoid formal default presented as an absolute must (again, just look at Greece).
In retrospect, it feels like the high water mark of central bank independence was probably over a decade ago, when Federal Reserve chairman Alan Greenspan was dubbed The Maestro. Since the current crisis hit, that independence has been ebbing away at an accelerated rate. Some central banks (the Fed) have appeared more willing than others (the ECB) to "accommodate" the aims of government with lower policy rates and other "unconventional measures". One by one, though, they have toed the line.
In an extreme scenario, with government unable to borrow at sustainable rates, it would be sorely tempting to get round the problem with QE. The results of giving in to such a temptation could be catastrophic.
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