Credit rating downgrade - does it matter and who does it help?

Moody's, one of three 'Credit Ratings Agencies' has downgraded the UK governments credit standing from AAA (the best rating meaning 'very safe' to lend to) to AA1 (meaning 'pretty much safe' to lend to).

So what difference does this make? All loans require a rate of interest to be paid. The rate charged is made up of several elements, such as a 'pure' element - the profit to the lender - an 'inflation protection' element - the lender gets back what they lent in real terms - and a 'risk of default' element. The last one means the premium charged to protect the lender against the chance of not being repaid. The credit rating is about that element. When a country or firm has a AAA rating then this element can effectively be zero; there is no risk of default.

To the extent that the UK government will always repay its debts then there is no risk of default. So AA1 shouldn't really make a difference to lenders. But if it did and lenders started demanding higher interest rates then this will increase the already significant interest rate bill to be paid by taxpayers each year (currently about £50 billion).

Further if the government has to pay more to borrow so will everyone else. Lenders will be attracted to lend where rates are highest. To get them to lend to mortgage borrowers the interest rate will also have to rise, otherwise they will lend their money to safe governments. So, as the Chancellor has been at pains to point out, the government paying more interest affects all borrowers.

If firms and consumers have to pay higher interest rates then Consumption and Investment will not rise as fast as hoped and recovery will be further delayed.

Ed Balls blames the government and says it is all their fault for not borrowing more. If they had done then the economy would have grown faster and this problem would have been avoided. (Moody's blame slow growth for the downgrade).

The Chancellor says had the government not cut the deficit (well tried to) then this downgrade would have come much sooner.

It is not clear which version of events is right. Balls has the problem that a credible deficit reduction plan is essential to keep the credit rating and must contend with the ineffectiveness of stimulus policies generally. Osborne faces a rising deficit and missed targets with very poor growth.

Whoever is right the downgrade will make little difference in reality. France and the USA continue to borrow at record low interest rates despite being downgraded already. Two of the three rating agencies have not yet downgraded the UK.

Perhaps the most obvious point to make is that these same rating agencies stamped the mortgage backed securities that turned out to be worthless and caused the Global Financial Crisis 'Triple A'. Their credibility is pretty low and one of them is currently being taken to court by the US government for their role in misleading investors.

The BBC covers the story here, but look at the website directly to cover latest updates.

End of recesion or just heading for VW?

People often talk about the shape of a recession. The 'best' is V shaped - a short and sharp drop in GDP with a rapid recovery. U shaped is second best, still a strong recovery. The dreaded L shaped is the one to avoid and the reason why the policy response was so robust in 2008/9.

The UK has now officially reached the end of the W shaped - double dip - recession. Feared for so long and lengthened by the one-off impact of the Jubilee. Officially the UK grew by 1% in the quarter July to September, the fastest growth for five years.

Actually there were special considerations for this growth spurt, mainly the Olympics and the 'catch-up' from the previous quarter, so don't get too excited yet.

The headline figure is, as always, hiding a lot of detail. Look at the BBC economy page for that. It should be noted that the construction sector really is the problem area at present.

Construction continues to shrink and is making a really big impact on the figures. We should be worried about this. Not only does construction employ a lot of people and use lots of locally produced resources, but it is also a 'leading sector' in recoveries. We would expect construction to turn up before we saw a sustained rise in Real GDP.

The other point that might be worth noting is that the economy shrank by 6.4% in the first 'dip' and so far only half of that has been recovered even counting the last quarters growth.

Below is an article by The Guardian's Larry Elliott. You could not find a more miserable and biased economic commentator and he puts the latest recovery in the worst light he can. I'm surprised he wasn't the first to name the next stage as the triple dip or VW shaped recession. Glad I got in first!

Elliott's article is here

Saving the Euro or just delaying the inevitable?

I can't do justice to this subject in a post. The Euro crisis has so many issues and aspects. But the agreement reached yesterday is certainly important and adds to the story in a way that does sum it up to an extent.

The Euro area countries have agreed to

* Cut by half the amount Greece owes the banks (reducing their total debt and so not only the amount they will repay but also the annual interest).
* Recapitalise the banks so they are better able to withstand further shocks (say a default by Italy or Spain)
* Increase to €1 trillion the bailout fund available in case of potential default.

The markets love it and have soared, but should we be so sure?

The French President stated that 'Greece should have never been allowed to join the Euro' because they were not ready and falsified the figures. Well he is probably right and the fact that the Euro area is not an 'optimal currency area' has not gone away. Maybe this isn't the time to say France 'managed' the figures too to meet the joining criteria, but it is certainly true that Belgium and Portugal should not have the same currency.

The 'partial default' that the 50% cut in Greek debt represents is a managed way to prevent a full default. That would cause panic and probably the break up of the Euro area. That would be disastrous for trade - what does anyone do between the Euro and the 'new' currencies that would replace it? Months of lost trade, shutdowns and unemployment would be inevitable and that would affect the UK too, with 60% of visible trade done with the EU.

As one commentator said. 'What the Eurozone needs is growth'. This will solve many problems. The debt to GDP ratio will fall, and governments will have more revenue and lower expenditures, allowing them to service their debts. Growth will also allow confidence to return and the growth will become self-sustaining.

But the recapitalisation of the banks will slow growth. For banks to have more capital they have to keep more of their assets, and that means lower lending. Lower lending leads to a credit squeeze and firms can't get the capital they want. Interest rates will probably rise as firms demand more loans and the price rationing process kicks in.

Perhaps the most worrying aspect is that €1 trillion is nowhere near enough to bail out Italy let alone Spain and Italy together. The Euros inherent weaknesses remain and in all probability this is just a temporary lull in the crisis.

The BBC covers the issue here

Dealing with a different sort of recession

Political debate usually generates more heat than light. That is one of the basic rules of life and the political debate over policy to deal with the recession illustrates this well. So we have to try and look through the politics of the latest announcement.

The last recession was caused by a collapse in financial markets which, by various means, led to a collapse in Aggregate Demand. A prudent response by most governments was to pursue an expansionary fiscal and monetary policy. This was to deal with the immediate effects of the crisis.

The debate now rages on how to continue to cope with the crisis, especially now that a 'double-dip' recession seems a possibility. Sadly at least one group in this debate have missed the point.

The Keynesians have, as usual, crawled out from under their stones and claimed they have the answer. 'Boost Aggregate Demand by the government spending more money', which they borrow. But Keynes was talking about a recession caused by a failure in the goods market in the General Theory, not one caused in the financial markets. (Read the General Theory if you like, it's pretty obvious. There is a copy at the back of Mr Lewis's room and online).

The time for old fashioned demand management has passed. It is necessary to deal with the financial market problems, such as the European Debt Crisis and Bank re-capitalisation. But this has led to a drying up of funds available for lending to businesses and this is preventing a timely recovery in the private sector.

Despite encouragement banks find they cannot both re-capitalise their balance sheets (so they can survive a second GFC or major default by Euro area countries) and lend to small and medium size businesses. This prevents those businesses expanding and reducing the unemployment problem.

Small and medium size businesses basically have two sources of capital, loans and retained profit. Unlike in the USA (where such bonds are a major source of funding) they cannot easily issue 'corporate bonds' as there is no established market for them.

So now the Chancellor is proposing to help develop this additional source of funding by offering to buy bonds issued by smaller firms. It is an unusual, and potentially far sighted, move to help recovery. It is, however, fraught with difficulties.

As the market for small firm bonds is currently tiny it is likely the costs of operating in this market will be high. It will also take time to establish and the firms that can benefit will find it is some time before they are ready to issue bonds. However they now have a guaranteed buyer in the government and so they can raise money with certainty and, presumably, at a lower cost than any alternative. The government hopes it will allow the development of a small/medium firm bond market that will persist in the future.

The measure is being called a credit easing plan. It directly addresses an issue caused by a financial market induced recession and so should be applauded. I would call it a 'supply side' measure as it is trying to help a market work, is specifically targeted at an issue, will allow the expansion of productive capacity and will take a long time to work.

Time will tell how effective it is.

The Guardian reports the measure here

Operation Twist - Probably misinterpreted

I know this post is challenging and is aimed at A2 students only. However it is a very important recent development in monetary policy.

The Federal Reserve has undertaken a restructuring of the debt it holds in an attempt to lower long term interest rates. This has become known as 'Operation Twist', but this is mainly because people want more.

The Fed has tried to lower long term interest rates by causing an excess of demand in the market for long term government debt. This is done by withdrawing from the market long term debt by buying it themselves. Such government debt is an important part of many investment funds portfolios, for example pension funds.

As a result there is less long dated government debt on the market and so the price of the remaining debt is bid up. A government bond pays the holder a fixed amount each year, say $2 for each $100 of the face value of the bond.

As the price of the government debt rises then the annual payment made by the government to the holder of a bond is a lower percentage of the market price. This means long term interest rates are lower. For example a $100 bond pays $2 a year. The market price of the bond is forced up t0 $200 and so the $2 paid now represents a rate of interest of just 1%.

So the Fed have tried to buy up long term bonds, taking them off the market, and replacing them with short term bonds. This will hopefully reduce the rates on all long term loans and so stimulate, for example, mortgage borrowing. This would encourage a recovery in the housing market which remains crucial in the USA.

The markets have taken this as a sign of panic. This has not helped confidence, hence the plunge in the stock markets. The markets also wanted more Quantitative Easing as they feel the economy needs a bigger boost.

I am far less clear on the Fed's motives. There was a time when central banks structured the debt in a way that was consistent with the interest rate set. Having more short term bonds on the market certainly increases the liquidity of the market and most commentators seemed to have missed this.

This is an unusual move by the Fed. It has been, at best, badly received and at worst seen as a sign that the policy options have run out. Most economists also doubt that the move will actually be effective.

The Guardian explains 'Operation Twist' here

London Riots highlight the failure of Capitalism

Before following the English press with calls for anarchy or a return to socialism it is important to examine the economic causes behind the riots. It has undoubtably been stimulated by some simply wanting to create havoc, however, could it also be a classic case of economic market failure illustrated through poor housing and lack of economic mobility? Is capitalist system failing minorities in London?

A fairly 'left field' view can be found here

When monetary policy stops working

Growth forecasts for the UK economy have been downgraded in recent months. There seems very little prospect of a return to normal growth until the middle of next year.

What is the standard response to this state of affairs? Economic stimulus packages.

There are problems here. As I pointed out in yesterdays blog the government are cutting expenditure and raising taxes to cut the budget deficit. Some argue this is too much, too soon and that the lost Aggregate Demand will push the economy back into recession, or at the very least inflict avoidable pain on the population. The counter argument is that the level of debt is unsustainable already.

Whatever the merits of the opposing views a fiscal boost to the economy isn't going to happen.

So that leaves monetary policy or supplyside policy. Supplyside policy promotes longterm growth, but will do nothing to aid shortterm growth. So monetary policy is all that is left.

The MPC reduced interest rates to 0.5% and kept them there. There is no more they can do to encourage consumers and firms to borrow and so boost Aggregate Deamnd on that front. Monetary policy in this sense has hit its lower limit.

So the other possibility is to print money. The newly created money will find its way into the pockets of consumers and the level of AD will rise. This is done by 'Quantitative Easing' with the Bank of England buying up financial assets (almost always Government Bonds, but not necessarily) with money they simply create.

Some scream this will be inflationary, but that isn't the case if real output can rise to meet the increased demand. At least one member of the MPC, Adam Posen, thinks more Quantitative Easing is needed and more people are coming around to this view.

The prospect of a stimulus to the British economy may improve consumer and business confidence and get them borrowing at the historically low interest rates on offer. Frankly more 'QE' is unlikely to do any harm.

The Guardian reports Posen's views here

Greece! Should the euro stay?

Increasing the British government is becoming sceptical about Greece's ability to pay back its' public debt and has not attended the latest bailout meetings. The issue is: Can Greece be saved and is it worth saving? Few doubt that the failure of Greece will lead to lower growth in the Euro region (where over half of the UK exports are sold). However the bailout seems to be increasingly viewed as a simple delay tactic and that defaulting on the debt is unavoidable.

http://www.guardian.co.uk/politics/2011/jun/20/treasury-minister-faith-in-euro-falters