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Goodbye Triple A. Hello Triple Dip?

By David Bailey on Feb 25, 13 10:31 PM in

Last week the UK lost its AAA rating with the rating agency Moody's. That wouldn't really be a big deal except for the fact that the Chancellor had made it the centre piece of his economic strategy. That was never a good idea nor was the associated deficit hysteria from the Chancellor and his headlong rush into austerity.

Remember that the chancellor actually inherited an economy that was growing - tentatively - in 2010. Since the 2010 General Election, the UK economy has grown by just 0.5% (and even that was probably down to the Olympics).

Osborne famously stated back in 2010 that he was going to "cut the deficit more quickly to safeguard Britain's credit rating. I know that we are taking a political gamble to set this up as a measure of success. Protecting the credit rating will not be easy. But the economic risk of not setting ourselves this benchmark is not one that I am willing take ... we will protect Britain's credit rating and international reputation."

Yet last week, for the first time in British history, Moody's downgraded the UK. It didn't even wait to see what Osborne came up with in his budget next month. Actually it was no great surprise. With minimal growth, Moody's anyway had the UK on negative watch.

Osborne himself had said that making the credit rating the measure of success was a gamble - as I noted in my Birmingham Post commentary on the emergency budget back in 2010. In fact, it was an unnecessary gamble. Remember that Osborne was supposedly trying to retain 'market confidence'.

The effect has instead been an undermining of business and consumer confidence in the economy more generally, followed by a flatlining economy and in turn a loss of that market confidence he sought to retain. That's a failure of economic policy on the government's own terms.

Meanwhile trying to pin the blame on the last lot is getting harder to pull off as time goes by and as the economy continues to flatline. The bottom line is that the current government underestimated the effects of fiscal tightening on the broader economy. They were warned, of course, but dismissed that criticism.

Of course, the downgrade is no big deal in the sense that several countries have been downgraded in recent years and haven't necessarily seen the costs of borrowing rise (the US, France and Japan most noticeably) but it is nevertheless something of a humiliation for the government in general and George Osborne in particular.

What does the downgrade really mean? The last time the UK (or rather England) defaulted on its debt was 600 years ago. And despite George Osborne's best efforts to compare the UK to Greece at the last election, the UK is not Greece. The risk of a UK default is zilch.

Does it mean a higher risk of inflation or exchange rate risk? Maybe - but that's quite a different thing to the risk of a default and anyway are ratings agencies really of any use whatsoever in actually judging such things?

The ratings agencies didn't exactly cover themselves in glory in the run up to the financial crisis after all and we should never have got hung up on what they said. But George Osborne did and that's why his credibility is now badly dented.

And I doubt very much if the downgrade will have any material impact on the gilt market. Despite their downgrades, yields on French and US bonds are still extremely low in historical context - and are actually below where they were before the downgrades.

In fact there were three main reasons why Moody's downgraded the UK:

1. The weakness of the UK economy which has hardly grown at all since 2010 and which is still 3.5% smaller than before the financial crisis;
2. the dismal state of the economy in turn means that the government has had to keep postponing the target date for eliminating the structural deficit well into the next parliament; and
3. the fact that the UK economy is less placed to respond to any new shocks (which by the way was meant to be a reason for 'expansionary fiscal contraction' - again a failure of policy on its own terms).

Actually, the downgrade could make it easier for the Chancellor to change track (if only he had the political courage to do so) and also the resulting depreciation of sterling should help make exports more competitive and help boost the 'rebalancing' of the economy that the government professes to desire.

Osborne though doesn't seem to be someone who changes his mind if the facts change. Hence his comment at the weekend that "far from weakening our resolve to deliver our economic recovery plan, this decision redoubles it."

Rather, Osborne has effectively painted himself into a fiscal corner and looks increasingly like someone stuck in no man's land. Cut faster and the UK could tip into an unprecedented triple dip recession. Ease off and he is wide open to criticism of ditching his strategy.

Sit tight and hope for something to turn up seems to be the current growth strategy. The Chancellor could be waiting a long time.

Professor David Bailey works at Coventry University Business School

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