The credit ratings agency Fitch has downgraded the UK's sovereign debt by one notch to AA+ from AAA.
This was not unexpected: the UK has been on "negative watch" for some time and was downgraded by Moody's not long ago. However, the terms of the downgrade are distinctly odd.
Firstly, let's remind ourselves what the purpose of a credit rating is. For sovereign debt, it is supposed to give investors an indication of the risk of loss due to default. Therefore it will assess the conduct of fiscal and monetary policy in the country concerned in the light of key macroeconomic indicators. Neither the indicators themselves, such as the projected path of GDP, interest rates and debt/GDP, nor the economic policies alone are a sufficient indicator of default risk. Both are needed to give a reasonable assessment of the likelihood of sovereign default and/or debt restructuring.
Credit ratings are NOT intended to give a general indication of the health of an economy. Nor are they intended to indicate risk of indirect losses due to inflation or low interest rates.
So the downgrade indicates that the UK is considered slightly more likely to default on its debt than countries such as Canada and Norway that still have AAA ratings.
The justification for this is the UK's weak economic performance, which despite government's best efforts to contain public borrowing is creating a rising debt trajectory - now expected to peak at over 100% of GDP - and large fiscal and current account deficits. Fitch correctly notes that the rising proportion of debt/GDP increases the financial fragility of the UK economy, making it less resilient to economic shocks.
That seems reasonable, doesn't it? Except that Fitch then goes on to undermine the entire justification for this downgrade by pointing out that there is virtually zero chance of a "self-fulfilling fiscal financing crisis" because of the UK's status as a reserve currency issuer and the Bank of England's willingness to "intervene in the government debt market" (i.e. buy sovereign debt). If there is virtually zero chance of a fiscal financing crisis, then there is virtually zero chance of debt default. In which case, what exactly is the point of this downgrade?
Fitch implies that, rather than allowing the UK to default on its debt, the Bank of England would monetise it. Now, the risk from monetisation is inflation. But a credit rating does not assess the risk of losses due to inflation. It is supposed to assess the default risk. If, as Fitch suggests, the Bank of England would as a last resort monetise debt, there is ZERO risk of default.
It is worth pointing out at this point that Fitch's implication that as a last resort the Bank of England would monetise debt ignores the fact that the UK is a member of the EU, and monetary financing of government is explicitly forbidden under the Lisbon Treaty. Whether or not the UK's debt does indeed have an increased risk of default therefore depends on the UK's commitment to the EU. The current government is perhaps a little wobbly on that: it may well be that, as a last resort, it would break the Lisbon treaty to prevent debt default. In which case there is still zero risk of default, though there might be considerable political and economic instability from such a course of action. However, if the UK chose to abide by its treaty commitments (not to mention its self-imposed limits on the extent of sovereign debt purchases by the central bank), then there would be some risk of default as large-scale monetisation of debt would not be an option.
But there is a more fundamental issue here. Fitch notes that the UK's public debt is denominated exclusively in domestic currency. A sovereign currency-issuing government should never default on its domestic-currency sovereign debt obligations, since it can always create money to settle them. Debt default for a sovereign currency issuer is a therefore a POLITICAL decision, not an economic one. Fitch's downgrade amounts to a vote of no confidence in the Cameron government, and particularly in the Chancellorship of George Osborne. And the timing of the announcement is exquisite, coming as it does at the end of a week which saw bad labour market figures, criticism from the IMF of the Chancellor's economic strategy, and the exposure of fundamental flaws in an economic theory frequently used to justify aggressive deficit reduction measures.
For this reason, illogical though it seems, the Fitch downgrade should be taken seriously. The Government does not give the impression of being competent. Frequent U-turns on changes to taxes and benefits, poorly thought-out reforms of entitlement programmes, lack of coherent investment strategy, propping of an overblown housing market, failure to tackle bank reform, undermining of expansive monetary policy with ill-considered fiscal tightening.....none of these look like the actions of a Government that has the faintest idea what to do with a stagnant economy and damaged financial system. What is worrying is there is little evidence that the Opposition's ideas are any more coherent. Only today the Labour party outlined changes to the unemployment benefits system that would leave people in debt when they found a job: it was billed as "putting 'insurance' back into National Insurance", but I've never heard of an insurance system that forced people to repay money paid out under the scheme.
The biggest risk to the UK economy, and therefore to the safety of UK sovereign debt, is the clowns running our political system. Heaven help Mark Carney. He has a simply horrible job to do.
Fitch downgrades United Kingdom to AA+ , Outlook Stable - Fitch Ratings (press release)
Moody's downgrades UK's government bond rating to Aa1 from Aaa: outlook now stable - Moody's (press release)
UK unemployment rises to 2.56m - BBC
A Bad Week for UK's Osborne - CNBC
Reframing Reinhart & Rogoff - Coppola Comment
Labour plans student-style "salary loans" for the unemployed - Guardian