Monday, 8 August 2011

Why has the US been downgraded from AAA and not the UK, and what will it mean for us?


The ratings agency Standard & Poor’s has downgraded United States sovereign debt overnight, from AAA to AA+. They are one of the big three agencies alongside Moody’s and Fitch, so it is a significant and unprecedented step. There are two obvious questions: Why has the US been downgraded and not Britain? And, what does it mean for us?

In their statement about the downgrade Standard and Poor’s answer the first question. Contrary to some early reports, they don’t attach particular blame to any party or ideology. Their view is essentially that they don’t see the political will to take sufficient action to address the deficit there in the medium term:

When comparing the U.S. to sovereigns with ‘AAA’ long-term ratings that we view as relevant peers–Canada, France, Germany, and the U.K.–we also observe, based on our base case scenarios for each, that the trajectory of the U.S.’s net public debt is diverging from the others. Including the U.S., we estimate that these five sovereigns will have net general government debt to GDP ratios this year ranging from 34% (Canada) to 80% (the U.K.), with the U.S. debt burden at 74%. By 2015, we project that their net public debt to GDP ratios will range between 30% (lowest, Canada) and 83% (highest, France), with the U.S. debt burden at 79%. However, in contrast with the U.S., we project that the net public debt burdens of these other sovereigns will begin to decline, either before or by 2015.

Britain’s credibility has always rested on an assessment by the markets and the ratings agencies that people here do accept cuts are necessary. As I quoted in How to Cut Public Spending, Moody’s specifically credited that as a key reason to maintain our AAA rating before the last election, despite the parties largely avoiding a serious and specific discussion of cuts at that point:

Moody’s assessment that the UK government exhibits a high degree of debt reversibility is supported by the trend over recent months towards an apparent consensus among the public that fiscal retrenchment (including cuts in expenditure) is both inevitable and desirable.

Thankfully the people we are borrowing so many billions from understand that most Britons do want to deal with the deficit, they trust that the irresponsible “no cuts” brigade are a small minority.

It will be Monday before we have a clear idea of what this means for Britain. There are two key questions.

First whether the ratings agency is essentially following markets which have already priced in that US debt is a lot more risky than it used to be. Or whether this is another event like the Lehman’s collapse or the events in Greece that alters investors’ perceptions of what is safe quite drastically, and therefore causes a lot of disruption in world markets. We will find out on Monday.

The second question is whether or not the fact in itself that this debt is no longer unambiguously rated as AAA will force some institutional investors to move their money. If all the agencies changed their ratings that would almost certainly be the case. But if Moody’s and Fitch keep the US at AAA then it might not happen. Again we will get a clearer picture on Monday.

It still looks like the eurozone’s problems are the biggest threat to the global economy right now. Italy and Spain’s problems are much more urgent.

I don’t think this should change our policy priorities. We still need to keep up the fiscal adjustment to maintain our credibility, so that ratings agencies don’t come to the same conclusions about our will to sort out our public finances they have come to about the US. But also with so many dangers in the international economy we need supply side reforms to strengthen the underlying strength of our economy. Not more spending, which is generally associated with lower economic growth, but improvements in incentives for people to work, invest and build businesses in Britain. We can’t leave opportunities like more dramatic cuts in business taxes on the table and we need to look at the deeper reforms the 2020 Tax Commission is studying.

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