The most surprising thing about UK’s credit downgrade is that it took so long, even by credit ratings’ agencies standards, for Moody’s to move the UK to AA writes Ralph Blake. We had forecast the slump the coalition was going to create in June 2010¹.
Given that France with similar levels of debt but a stronger economy was downgraded over one year ago, why did it take so long to downgrade the UK? Part of the reason is that credit agencies share some of the political economic theory of Osborne and all: austerity will somehow stimulate growth and create higher tax revenues reducing the deficit and creating jobs.
The opposite of this has of course happened. UK public debt has grown to £1265 billion at the end of February 2013. The figures the government use as a headline number are about £120 billion lower as they exclude the debt issued for the bailouts of the financial system – the root cause of the spiral of deficit and debt that we are in! Half of this £120bn is unrecoverable and 20% of the remainder used to bailout RBS and Lloyds has been written off by the government.
Our total debt stands at 88% of real GDP (the figures used to calculate official growth numbers) or 82% of notional GDP which only the UK government uses and takes no account of inflation. Using this notional GDP the economy would have grown 7.6% since the financial crisis instead of shrinking 3.2%! As well as experiencing the worst recession since the 1930s we have witnessed the worst recovery from a recession since the 19th century. In other words we are in a slump.
The financial markets have of course recognised this well before the ratings agencies. UK government borrowing costs have risen at one point by 50% since last August last year while at the same time Sterling has weakened against a basket of major currencies by 8%.
The deficit, which has to be funded by issuing new debt, has not been brought under control as Osborne promised. It looks for financial year 2012/2013 to at least going to match the previous year’s figure of £121 billion. Since the financial crisis we will have piled on £760 billion of debt at an average of £152 billion per year. Prior to the financial crisis the annual deficit was running at £30 billion a year. This puts paid to the lie that the deficit/debt is the fault of superfluous reckless spending on services. It’s clearly directly linked (excluding the average £30bn per year deficit prior to the crisis) to: the bailout of the financial system (£120bn); subsidies to stop the 2008/09 recession turning into a depression (£45bn); the fall in tax revenues from individuals and companies because of the recession; and the increase in welfare sending to support the 3.5 million people who have been made redundant² since the financial crisis (£445bn).
So although services are being cut the deficit remains high because of the number of people who have to be supported from being made redundant since the crisis. Those who have found fresh work are either now working part-time or on much lower wages or notionally “self-employed”.
The climate of austerity is not helping any recovery but we must recognise that the UK economy was based on a service industry fuelled by credit, private housing and financial services. This financial bubble economy has burst globally and we would have lagged without austerity other major mature economies.
A giant Ponzi scheme
Who then is buying all this debt? The simple answer is that we ourselves are buying it through a giant Ponzi scheme. We have all heard of the Bank of England (BOE)’s Quantitative Easing (QE). But what is QE? Essentially, the BOE prints money that it technically borrows from itself at the base rate 0.5% per year. The government sells fresh debt each month to cover the month’s deficit between spending and tax revenues. The debt is sold to intermediaries such us pension and hedge funds. These funds then sell it to the BOE who pay for it using the money they have printed. We the tax payer pays the interest to BOE and repays the debt in full when it expires. So far the BOE has bought an incredible £375bn worth of UK government debt through this QE method, about 60% of the debt the government has issued over the last four years. Without QE our borrowing costs would be much higher.
The dilemma for the government is that QE is finished and with a weak pound and downgrade the demand from foreign investors for UK government debt will fall – 36% of our total debt is held overseas. This will push up the cost of borrowing for the UK. This is why there is a clamber within Downing Street and the BOE for more QE to take up the shortfall in demand for our debt. But there is a limit to the size of QE because of the loses that could be incurred by BOE, and ultimately us, if interest rates were to rise and bond prices fall.
We are now going into a phase of a slump, weak pound with imported inflation and a recognition that the structural weakness of the UK economy plus austerity means UK plc. Is not a very attractive place for investors? This will lead to higher borrowing costs which means the coalition will drive through more austerity to try and meet their austerity targets but that as we know just prolongs and deepens the slump and the deficit. Unless there is a plan B put in place that uses revenue from tax avoidance, the banks, taxes on the rich and wealthy and nationalised North Sea Oil revenues to finance public projects then the UK is heading for a serious currency and debt crisis.
Ralph Blake is a financial analyst and former head of strategy and research in investment banking.