Yesterday, the - Flash Germany PMI - was released, which shows that "German business activity"…
Companies that sell shonky products under false pretenses are typically prosecuted by the authorities. Those that sell shonky products generally are typically run out of business. But there is one class of such products that seem to escape the scrutiny of both the authorities and the market. Indeed, they seem to have bluffed many governments into believing that shonky is good. Last week, the patently irrelevant Moody’s rating agency downgraded Britain’s sovereign debt ratings from Aaa to Aa1. The fact it was headline news indicates how stupid we all are. The fact that George Osborne then had to lie about what it meant showed how stupid he is. The fact that the Opposition leader described it as a humiliating blow showed how stupid (and opportunistic) he is. How a company that was complicit in the financial crisis can command so much free advertising is beyond me. I must be stupid! The fact is that the latest ratings are without meaning or import.
The ABC (our national broadcaster) has a program Business Today and it featured the ratings downgrade. The first segment was a cross to a so-called expert in Sydney holding a tablet to look important with her private bank’s logo occupying about half the screen in the background. The ABC has a strict non-advertising policy. Since when does one of the big four banks get free advertising on our national broadcaster
It wasn’t as if the analysis was worth listening to. We got gems like the Moody’s decision was “Well priced in” and that she was “Not expecting a market reaction today on the market”, which I thought was about the most intelligent statement among the 2 minutes of platitudes. Really, play school is better than that trash that goes as informed reporting.
The segment that followed featured George Osborne saying that the downgrading confirmed everything he has been saying – too much debt. He lied.
The press release (February 22, 2013) – Moody’s downgrades UK’s government bond rating to Aa1 from Aaa; outlook is now stable – outlines the “key interrelated drivers” of the decision to downgrade:
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.
If someone out there who knows anything can tell us how any of these “drivers” can alter the following realities then please come forth:
1. Britain issues its own currency.
2. Britain has total control of its own fiscal and monetary policy.
3. Britain floats its currency.
4. Britain has never voluntarily refused to honour its liabilities under these arrangements.
I am sure there is someone out there who wasted their cash and bought the book by Reinhart and Rogoff about sovereign debt defaults. Even on the remainder desk, the book is not worth the money. At any rate they will claim Britain defaulted in 1932, which is near enough in history to be worried about.
The reponse is that Britain did not satisfy conditions 1-3 as above.
But at any rate, the “default” was an invitation only to bond holders to take a lower interest rate and extend the maturity date on the 5 per cent War Loan Bonds, which were issued in 1917 to “pay” for the prosecution of the First World War effort.
At the time (June 30, 1932), the British Prime Minister (Neville Chamberlain) told the – British Parliament – that:
Talk of conversion, has been in the air a long time, and naturally so, for it has been growing increasingly obvious that the War Loan at 5 per cent was out of relation to the yield of other Government securities, and, moreover, that the maintenance of that old War-time rate attaching to so vast a body of stock and hanging like a cloud over the capital market was a source of depression and a hindrance to the expansion of trade …
After a long period of depression we have recovered our freedom in monetary matters. We have balanced our Budget in the face of the most formidable difficulties, and we have shown the strongest resistance of any country to the general troubles affecting world trade. I am convinced that the country is in the mood for great enterprises, and is both able and determined to carry them through to a successful conclusion …
It is my confident hope that the great mass of the holders will respond to this invitation …
For the response we must trust, and I am certain we shall not trust in vain, to the good sense and patriotism of the 3,000,000 holders to whom we shall appeal.
The reference to regaining its “monetary freedom” was the decision to abandon the Gold Standard (temporarily) in September 1931, after the Bank of England lost nearly all of its foreign currency reserves trying to defend the Pound, which depreciated sharply after the decision.
However, despite struggling through the 1920s, the British government held onto the budget surplus mantra, which Chamberlain’s government was still holding out as a virtue in the midst of the Great Depression. So even though they abandoned convertibility they really didn’t understand what “monetary freedom”, as the currency issuer, required in the face of major non-government spending collapse.
In other words, even if the terms of the bodn issue at the time were nonsensical, the 5 per cent yields was in no way a “source of depression” nor a “hindrance of trade”.
The source of depression in the UK at the time was the fiscal drag arising from the obsession with budget balance and the weakness of private spending. The “Treasury View” exacerbated the problem by trying to solve the rising unemployment with money wage cuts.
In fact, the income flow from the bonds were supporting growth and the conversion offer had the effect of stifling growth because 90 odd per cent of the bond holders, which included households as well as large institutional investors agreed to the offer.
The other obvious point to note is that the so-called “default” was not any such thing. It was a voluntary offer which could have been rejected. The Government did not propose to coerce investors and force non-payment. It just said “be nice Brits and believe our lies and give up some of your income entitlements”. Most did but that is not the point.
But in the modern day, the sovereign debt ratings are about “credit risk”, which means the investor faces a risk of not being paid the amount they expect at the time they contract for.
One of the big four ratings agencies offer the following – definition:
Credit ratings are forward-looking opinions about credit risk. Standard & Poor’s credit ratings express the agency’s opinion about the ability and willingness of an issuer, such as a corporation or state or city government, to meet its financial obligations in full and on time
That definition is representative.
The conclusion is that in the case of a private firm, the ratings may have some relevance, given that such debt carries a risk. Whether the corrupt ratings agencies are the appropriate vehicle to provide the “markets” which such intelligence is another matter.
But in the case of sovereign debt (by which I mean a government satisfying the terms above 1-3, plus not issuing any debt obligations in a foreign currency) the ratings are irrelevant. Why we think otherwise is a mystery that can only be explained as falling into the same class of transactions as the shonky salesperson trying to sell new immigrants the Sydney Harbour Bridge.
In other words, fraud.
The same company also offers a document – Sovereign Government Rating Methodology
And Assumptions – outlining in general terms what sovereign debt ratings are all about.
The opening salvo says that the document:
… provides additional clarity by introducing a finer calibration of the five major rating factors that form the foundation of a sovereign analysis and by articulating how these factors combine to derive a sovereign’s issuer credit ratings …
Clarity and articulation are about education. Education is about knowledge.
While the documents very authoritative it doesn’t take long to find that it presents a confused conflation of different monetary systems, exchange rate arrangements and pure conservative ideology – which means it should be disregarded as mis-informed hype rather than insightful analysis.
Paragraph 11 gives the game away:
A sovereign local-currency rating is determined by applying zero to two notches of uplift from the foreign-currency rating following our methodology outlined in subpart VI.D. Sovereign local-currency ratings can be higher than sovereign foreign-currency ratings because local-currency creditworthiness may be supported by the unique powers that sovereigns possess within their own borders, including issuance of the local currency and regulatory control of the domestic financial system. When a sovereign is a member of a monetary union, and thus cedes monetary and exchange-rate policy to a common central bank, or when it uses the currency of another sovereign, the local-currency rating is equal to the foreign-currency rating.
That should be enough to tell anyone that those “unique powers” preclude credit risk unless there are extraordinary political factors, which would predispose a government to default voluntarily. Which would suggest that the ratings agencies were staffed by political scientists rather than economists who rave on about deficits and growth.
You will read on to find out the “overall calibration of the sovereign ratings criteria is based on our analysis of the history of sovereign defaults” and they use various data sources including Reinhart and Rogoff. They consider the data to be continuous from the “beginning of the 19th century”.
A lot of commentators have seized on the recent book by Carmen M. Reinhart and Kenneth Rogoff entitled This Time is Different as an authority on the question of sovereign default. It might be an historical documentation of sovereign debt events. But trying to link these events and presenting them as a meaningful guide to the present day is where the problem lies.
Here is draft version of This Time is Different that you can read for free.
Of critical importance, quite apart from the other issues that one might have with Reinhart and Rogoff’s analysis (and I have many), one has to appreciate what they are talking about. Most of the commentators do not spell out the definitions of a sovereign default used in the book. In this way they deliberately (or through ignorance – one or the other) blur the terminology and start claiming or leaving the reader to assume that the analysis applies to all governments everywhere.
It does not. On Page 2 of the draft, Reinhart and Rogoff say:
We begin by discussing sovereign default on external debt (i.e., a government default on its own external debt or private sector debts that were publicly guaranteed.)
How clear is that? They are talking about problems that national governments face when they borrow in a foreign currency. So when so-called experts claim that their analysis applies to the “entire developed world” you realise immediately that they are in deception mode or just don’t get it … full stop.
Many advanced nation have no foreign currency-denominated debt. They might have domestic debt owned by foreigners – but that is not remotely like debt that is issued in a foreign currency. Reinhart and Rogoff are only talking about debt that is issued in a foreign jurisdiction typically in that foreign nation’s currency.
It turns out that many developing nations do have such debt courtesy of the multilateral institutions like the IMF and the World Bank who have made it their job to load poor nations up with debt that is always poised to explode on them. Then they lend them some more.
But it is very clear that there is never a solvency issue on domestic debt whether it is held by foreigners or domestic investors.
Reinhart and Rogoff also pull out examples of sovereign defaults way back in history without any recognition that what happens in a modern monetary system with flexible exchange rates is not commensurate to previous monetary arrangements (gold standards, fixed exchange rates etc). Argentina in 2001 is also not a good example because they surrendered their currency sovereignty courtesy of the US exchange rate peg (currency board).
Further, Reinhart and Rogoff (on page 14 of the draft) qualify their analysis:
Table 1 flags which countries in our sample may be considered default virgins, at least in the narrow sense that they have never failed to meet their debt repayment or rescheduled. One conspicuous grouping of countries includes the high-income Anglophone nations, the United States, Canada, Australia, and New Zealand. (The mother country, England, defaulted in earlier eras as we shall see.) Also included are all of the Scandinavian countries, Norway, Sweden, Finland and Denmark. Also in Europe, there is Belgium. In Asia, there is Hong Kong, Malaysia, Singapore, Taiwan, Thailand and Korea. Admittedly, the latter two countries, especially, managed to avoid default only through massive International Monetary Fund loan packages during the last 1990s debt crisis and otherwise suffered much of the same trauma as a typical defaulting country.
We have seen the circumstances of Britain’s 1932 “default”. Britain has never defaulted when its monetary system was based on a non-convertible currency.
A large number of defaults are associated with wars or insurrections where new regimes refuse to honour the debts of the previous rulers. These are hardly financial motives. Japan defaulted during WW2 by refusing to repay debts to its enemies – a wise move one would have thought and hardly counts as a financial default.
But if you consider the “virgin” list – how much of the World’s GDP does this group of nations represent? Answer: a huge proportion, especially if you include Japan and a host of other European nations that have not defaulted in modern times.
Further, how many nations with non-convertible currencies and flexible exchange rates have ever defaulted? Answer: hardly any and the defaults were either political or because they were given poor advice (for example Russia in 1998).
Reinhart and Rogoff don’t make this distinction – in fact a search of the draft text reveals no “hits” at all for the search string “fixed exchange rates” or “flexible exchange rates” or “convertible” or “non-convertible”, yet from a Modern Monetary Theory (MMT) perspective these are crucial differences in understanding the operations of and the constraints on the monetary system.
Further, if you consider the Latin American crises in the 1980s, as a modern example, you cannot help implicate the IMF and fixed exchange rates in that crisis. The IMF pushed Mexico and other nations to hold parities against the US dollar yet permit creditors to exit the country. For Mexican creditors this meant that interest returns skyrocketed (the interest rate rises were to protect the currency) and the poor Mexicans wore the damage.
It was clear during this crisis that the IMF and the US Federal Reserve were more interested in saving the first-world banks who were exposed than caring about the local citizens who were scorched by harsh austerity programs. Same old, same old.
What about the detail provided by Moody’s?
In their press release explaining the decision, they introduce several concepts of “risk” without really telling readers that they are not talking about sovereign credit risk.
We read about “interest rate risk” – which relates to movements in bond prices. We read aout “risk exposure” in the context of a further European slowdown impacting on the real GDP growth rate in Britain. That has nothing to do with the capacity of the British government to honour its liabilities.
But the “main driver” in their decision:
… is the increasing clarity that, despite considerable structural economic strengths, the UK’s economic growth will remain sluggish over the next few years due to the anticipated slow growth of the global economy and the drag on the UK economy from the ongoing domestic public- and private-sector deleveraging process ….
The sluggish growth environment in turn poses an increasing challenge to the government’s fiscal consolidation efforts, which represents the second driver … the rating agency cited concerns over the increased uncertainty regarding the pace of fiscal consolidation due to materially weaker growth prospects, which contributed to higher than previously expected projections for the deficit, and consequently also an expected rise in the debt burden …
More specifically, projected tax revenue increases have been difficult to achieve in the UK due to the challenging economic environment. As a result, the weaker economic outturn has substantially slowed the anticipated pace of deficit and debt-to-GDP reduction, and is likely to continue to do so over the medium term …
Taken together, the slower-than-expected recovery, the higher debt load and the policy uncertainties combine to form the third driver of today’s rating action — namely, the erosion of the shock-absorption capacity of the UK’s balance sheet. Moody’s believes that the mounting debt levels in a low-growth environment have impaired the sovereign’s ability to contain and quickly reverse the impact of adverse economic or financial shocks.
So pursuing fiscal consolidation causes the economy to tank (given slow private growth) which reduces tax revenue and means that the fiscal consolidation fails which is bad.
The circularity of the reasoning is mind-boggling. They support the fiscal austerity but also think slow growth is bad. Why? Not because it creates unemployment and rising poverty etc. But because it gets in the way of the financial goals it thinks are important.
First, they claim the currency issuing government has to reduce its budget deficit (engage in fiscal consolidation) because somehow a rising deficit is bad and erodes “the shock-absorption capacity of the UK’s balance sheet”.
Even that last statement is false and confusing. The balance sheet is a record of stocks whereas the deficit is a record of flows. A currency-issuing government can increase its spending and change tax rates any time it chooses.
There is no path-dependency of its capacity to do that. Running a surplus last period, provides the government with no extra capacity in this period to meet a spending gap opened up by an unexpected shift in non-government spending.
Running a deficit last period, provides the government with no less capacity in this period to meet a spending gap opened up by an unexpected shift in non-government spending.
In fact, we know that most times governments attempt to run surpluses (when the external account is not booming) a downturn soon follows as a result of the combination of the fiscal drag and the reliance on private credit expansion for growth.
These rating agencies seem to think that h means nothing at all. What fiscal space are we talking about? Earlier they admitted that the “risk of a fiscal financing crisis to be negligible”. That is, there is as much financial space for deficit spending as is required in the UK – as there is for any currency-issuing government.
There is near infinite financial space, which is the concept of “fiscal space” that they are referring to. There isn’t infinite real space – that is, the availability of real goods and services that can be purchased at any time with government spending.
But whatever is available for sale in UK Pounds – including all the unemployed and underemployed workers – can be purchased at any time by the national government. There is never an intrinsic financial constraint on that capacity.
Once again, we encounter lots of arbitrary (voluntary) constraints. When people say to me that the government has run out of money I just look at them (quickly recall which currency is being discussed) and say: What the Australian Government has run out of dollars?
The fact is that the British government can absorb any “adverse economic shock” at any time without exception. It might choose, as it is now, not to do so. But then the public debate would turn to examining why it was deliberately allowing unemployment to increase when it has all the means at its disposal not to have that happen.
Second, they acknowledge that the “the ongoing domestic public- and private-sector deleveraging process” is dragging down growth. Which means that their first demand – fiscal austerity – is creating the conditions that they think require a downgrade. You cannot win with that sort of logic. A is bad and has to alter but that causes B which is also bad and has to alter which would cause A to be worse which …. mindless logic.
Third, they note that the slow growth has made “projected tax revenue increases have been difficult to achieve” which is pushing up the deficit and debt ratio. Which any person with a modicum of understanding would realise was the obvious thing that would happen.
Why they thought that there would not be a increased deficit once the fiscal consolidation undermined growth is another matter that bears on their basic macroeconomic understanding in the first place. Like the IMF and the OECD, these agencies demand fiscal cuts, yet pretend that they will be offset by private sector spending growth. Even the most basic understanding of psychology tells us that confidence does not increase when sales are falling, jobs are being cut and unemployment is rising.
Fourth, in light of the weakening economy and the fact that the Government will not meet its deficit and debt reduction targets within the time frame specified in recent budget statements is also somehow bad. Why is a 90 per cent general government gross debt to GDP ratio any different to 80, 85, 120, etc.
What mindless rule is being applied here?
The whole thing is mindless. To repeat, the logic appears to be: Cut deficits to keep the Aaa rating – but that would undermine growth and push up the deficit and debt – which undermines the Aaa rating.
And the politicians and everyone else goes along with this nonsense. We really are not a very bright race of people.
Please read my blogs – Time to outlaw the credit rating agencies and Ratings agencies and higher interest rates and – Moodys and Japan – rating agency declares itself irrelevant – again – for more discussion on why the ratings agencies should be ignored and … outlawed.
The commentary by Moody’s has a lot to do with whether the government lives up to its promises (it won’t). It clearly has a lot to do with the capacity of the UK economy to grow (it won’t while all expenditure sources are in austerity mode).
The important point is what has all this to do with the default risk of the British government? The answer is none.
The bond markets certainly understand that.
The UK Debt Management Office define the – Bid-to-cover ratio
The ratio of the total amount of bids to the amount on offer at a gilt auction or a Treasury bill tender.
The following graph using – data – from the UK DMO shows the bid-to-cover ratios for the 10-year treasury bond auctions since the current government was elected. As the recent (February 21, 2013) – Wall Street Journal article – UK Gilt Auction Attracts Very Strong Demand – noted, the ratio is a “gauge of demand”.
The data runs from left to right in time (the most recent auction being the left-most column). The red line is obviously a situation where the demand is below the funds sought (which is often referred to as an “underbought” auction).
What does this tell us? In the vernacular – the bond markets have been consistently lining up for their dose of corporate welfare.
Every auction has been oversubscribed, which is the usual state.
Given their propensity to corrupt behaviour (as evidenced in the various hearings that have been conducted in the fallout of the financial crisis) I would outlaw the ratings agencies immediately.
But if I was in government I would also be engaging in a large education campaign trying to inform people about how moronic the logic used by these agencies is.
This is nothing more than a game of bluff and the government has the power but pretends it doesn’t. Ridiculous.
Tomorrow I am off to Dili (Timor Leste) and will be there until early Friday of this week. I have a lot of commitments and do not know whether I will find any time to write my blog. Maybe, maybe not. But if nothing appears then you will know why. I may find it hard to get connectivity even.
That is enough for today!
(c) Copyright 2012 Bill Mitchell. All Rights Reserved.