Follow Andrew on Twitter.
So the AAA has gone. Osborne said everyone should judge him as Chancellor and the government as a whole by whether we reduced the deficit and kept the AAA rating. Well, the deficit now seems certain to rise in 2012/13 compared with 2011/12, and the AAA has been lost. Some Labour economic commentators and a few maverick Conservative backbenchers are saying Osborne should therefore resign. Fair enough – you reap what you sow.
Why has the AAA gone? Moody’s statement says:
“The key interrelated drivers of today's action are:
1. The continuing weakness in the UK's medium-term growth outlook, with a period of sluggish growth which Moody's now expects will extend into the second half of the decade;
2. The challenges that subdued medium-term growth prospects pose to the government's fiscal consolidation programme, which will now extend well into the next parliament;
3. And, as a consequence of the UK's high and rising debt burden, a deterioration in the shock-absorption capacity of the government's balance sheet, which is unlikely to reverse before 2016.”
So, Moody’s says it has downgraded the UK because
a) growth is weak, which has undermined the deficit reduction programme
b) there are political risks associated with so much of deficit reduction being left to the next Parliament, and
c) the government balance sheet is vulnerable to further shocks (e.g. another deep recession or a bank collapse).
I agree completely with that analysis — indeed, I think it almost indisputable. Let’s reflect on these points in turn.
What have I said was the key problem for the UK economy ever since 2008? Answer: that, absent high and destructive inflation, if the average real growth rate from 2007-17 were only as high as market indicators implied one should expect (i.e. around 1% per annum or even less) then households would default on their mortgages, which would bankrupt the banks, which would in turn bankrupt the sovereign. We have already seen this happen in Ireland and Spain. It is not a “purely theoretical” concern. (It is worth noting that Spain had a AAA rating until 2010, and Ireland until 2009.)
At the time of the 2010 Emergency Budget, the Treasury thought the underlying growth rate of the economy was still 2.3% per annum, only a little down from the 2.5% normal from the 1980s to the mid-2000s. That being so, the UK had plenty of room to catch up in the recovery phase from the 2008-9 recession and healthy growth would drive increased tax receipts, cutting the deficit. We can see the breakdown of the government’s 2010 deficit reduction plan here:
Figure 1: Breakdown of Coalition's 2010 Emergency Budget Deficit Reduction Plan
By this point around 60% of the expected cuts in the deficit were to be achieved via growth, rising to around 70% by the end of the Parliament.
Unfortunately, some of us urged from the start that the government’s forecasts for underlying growth were overly optimistic. It was possible that, without the Eurozone crisis and if the second phase of QE had started in 2010, as it should have been, growth could have picked up in 2011 and 2012, but even then that would have been unsustainable and inflationary. We have seen since 2007 that whenever the economy is not actually contracting, inflation goes up to 5% and rising. If we had had strong growth, that inflation would surely have been even worse (and if we do get recovery now, expect it to be inflationary). The Eurozone crisis has simply smoothed out slow average growth.
Whether in the form of sustained near-stagnation or in the form of boom-and-bust, average annual growth from 2007 to 2017 is unlikely to be much above 1% and may be lower.
The government has failed to show the appropriate fear on this point, or to instil the appropriate fear in households. I had a friend once who confessed to me that he had used to think he was good at dealing with pressure, because he didn’t get nervous before exams or public speaking or other such events; now, however, he thought he was actually poor at dealing with pressure because he didn’t rise to it – he just flaked out. His “composure” was a cover for inaction.
In much the same way, the British economy has shown remarkable, and remarkably misguided, composure since 2010 (following a flurry of misdirected panic from late 2008 to 2009). We are now seeing signs of panic — the last MPC meeting had three votes for more money-printing even though inflation is expected to be far above target for at least two more years; the press is full of this Conservative backbencher or that proposing to spend more on infrastructure, have a huge tax cut, or both; the increased capital requirements the FSA imposed on the banks have now suddenly been relaxed.
A bit of panic will be healthy, provided we are not tipped over the edge into rout. The key focus of such action should be how to get more medium-term growth. To get more medium term growth we need to cut government consumption spending (spending cuts to approx 40% of GDP), increase the efficiency of government spending (markets, competition and profits in health and education), increase the workforce (raise retirement ages), facilitate the flow of credit (privatise the banks and reform regulation so we can allow the weak ones to go bust), encourage faster private sector deleveraging (raise interest rates).
We need to recall the old truth that it is only supply-side and structural reforms that can increase medium-term growth rates, not government borrowing or loose monetary policy. That is the central lesson of macroeconomics of the past 40 years, and yet people forget it so easily: if we have a medium-term growth problem we cannot solve it with fiscal or monetary stimulus, since neither fiscal nor monetary policy can increase medium-term growth; they can only reduce it if they are done to excess.
Turning to political risks, Moody’s is quite right to feel that the fact that such a high proportion of scheduled spending cuts are now in the next Parliament is a threat to the credibility of the cuts. What if a different party or Coalition were to win in 2015? What if it were the same Coalition but with a different Prime Minister? What if David Cameron (whose record on keeping promises is woeful), having won the Election, decided not to proceed with the cuts? Would those cuts ever happen?
That is particularly so because the government persists in its wrong-headed ringfencing commitments. For some reason it seems fine to this government to reverse any promise, or cut any Budget, except the NHS. The British economy is about the same size in real terms as in 2006, yet NHS spending is around £18bn more in real terms than in 2006. That’s more than 1% of GDP taken from productive activities that generate around 2% productivity growth per year to low productivity activities in the NHS that generate closer to a 0.5% annual contraction in productivity. The cumulative increase in spending since 2006 has been around £75bn. Imagine if that had been spent on investment or tax cuts during the recession?
It doesn’t seem to me to be anything to do with Right or Left. Why would it be more Left-wing or Right-wing to not cut benefit levels in real terms (as we are doing) but instead to cut NHS spending? It’s not about Left or Right but simply about priorities — the government seems to think it’s okay to cut the benefits of the poorest but not to cut spending on the sick. Neither is it anything to do with Election pledges. We pledged to keep the AAA rating and to eliminate the structural deficit over a Parliament, and earlier we’d pledged to cut inheritance tax. But Cameron thinks it’s fine to break all those promises but not fine to break the NHS ringfence.
It doesn’t make any sense, and other ministers are not going to put up with it much longer. The supposed Cabinet rebellion from May, Grayling and Hammond against further spending cuts on their departments was not an objection to spending being cut. It was an objection to the spending in their departments being cut whilst other departments remain ringfenced.
It will only be feasible to deliver the extra spending cuts required by the Coalition’s plans in the next Parliament if there are significant spending cuts to health, schools and pensioner benefits. Yet the government is making no efforts whatever to obtain consent from the public for this. (Arguably this is one of the great downsides of the Fixed Term Parliaments Act. By now we ought to have had two or three extra General Elections since 2010 and the political debate would have moved on dramatically. As things are there is statis, with the obsolete promises of 2010 trapping the politicians that made them.)
Since so much of the deficit reduction programme is politically questionable, Moody’s is right. The ways to address that? We could simply cut earlier. We could tell the public we’re breaking our promises on the ringfences. We could replace our leaders that made silly pledges they couldn’t keep with new leaders that didn’t make those promises. We could hold an early General Election. We could repeal the Fixed Term Parliaments Act. I’m recommending the cutting earlier and telling the public we’re not keeping our promises route, but if party colleagues find some of the other, more radical, routes more attractive, who can blame them?
Finishing with the shock-absorption issue, there are three key risks I see. First, any recovery will be highly inflationary leading to interest rate rises and another recession, a la 1980. An interest rate spike would impose huge losses on banks that hold government bonds on low yields, potentially bankrupting those banks unless the initial inflation spike is so high that it removes all credit losses for the banks’ borrowers. We can’t do much about that now, the Bank of England long having given up all inflationary credibility, but in truth there was probably never much we could do to avoid that. Second, if stagnation persists much longer we will see a snowball of households defaulting on their mortgages bankrupting banks bankrupting the sovereign leading to more recession leading to more households defaulting leading to even more bank problems, etc.. This was what happened in Ireland (AAA until 2009) and Spain (AAA until 2010). Third, if the government reacts to the loss of the AAA by giving up on its deficit reduction plan — e.g. by “spending for growth” on infrastructure or “tax-cutting for growth” on business taxes, there could be further downgrades and a spiral of worsening credit leading to government bond price falls leading to bank bankruptcies (since banks hold government bonds).
I’m not by nature a pessimist. I usually err on the side of over-optimism. When you reflect upon the above, reflect on this point too: over the past six years my warnings have been dismissed and mocked – dismissed in advance as far too gloomy; mocked ex post as having been far too sanguine. I fear I shall do no better this time.