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Credit downgrade – misinterpreting the signals

    Vuk Vukovic, lecturer of Political Economy and Principles of Economics at the Department of Economics, Zagreb School of Economics and Management (ZSEM), writes on the message sent by Britain's credit downgrade by ratings agency Moody's. 

    On Friday night the UK was given, for the first time in history, a downgrade of its credit rating, from AAA to AA1, announced by one of the rating agency oligopolists - Moody's. Here is their explanation:

    "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."

    Two things should be taken into consideration regarding the rating downgrade. Firstly, we should be aware of the fact that before the crisis the rating agencies were giving AAA ratings to what later turned out to be junk bonds (everything from Greek debt to MBSs were considered to be a risk-free asset), thereby completely misinterpreting the market risk of such assets. However, this had more to do with the issue of the rating agency oligopoly position, their erroneous business model and false assumptions on certain assets and markets, but most importantly the artificial demand created for AAA-rated securities before the crisis (more on that here). Nevertheless they still do provide investors with some kind of reference point on the plausibility of a country’s economic policy to end the debt crisis

    Second, this downgrade shouldn't be thought of as something inherently negative for the British economy. It will affect the government’s long term borrowing costs, but it won’t have a significant effect on households. It is by no means a signal for more fiscal stimulus (something that should be evident to any reader of Moody’s downgrade explanation). On the contrary, this should only create a stronger initiative for the British government to start with real structural reforms, and a proper way to conduct a fiscal consolidation.

    Going back to Moody's conclusions, all these things stand. Britain does have unsustainable levels of government debt, medium-term growth prospects are terrible, and is close to repeating the woeful 1990s Japan approach.

    Unfortunately, the Chancellor seems to have missed the message. He interpreted it only from one side of the coin: that Britain needs to persist in dealing with its debt. This is absolutely true. However, the other part of the coin implies the change of course of economic policy in Britain.  Simultaneously decreasing the tax burden and the regulatory burden along with substantive reorganisation of the inefficient labour market to tackle declining British productivity, are good ways to start. In other words, using the Swedish approach as opposed to the Japanese approach (two countries that experienced a similar structural shock in the beginning of the 90s, but had very different responses and very different outcomes).

    A rating downgrade for Britain shouldn't cause the same effect as it did in the US in 2011. However, in current times, it acts as a good signal of external enforcement to a government that seems to be missing more and more targets. It's a shame that it won't be interpreted as such, but that it will just go down as a reaffirmation of a faulty approach in a pointless political quarrel.

    Vuk Vukovic is a lecturer at the Department of Economics, Zagreb School of Economics and Management (ZSEM).

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    Comments

    Frances Coppola - About 2301 days ago

    If only the productivity puzzle could be so easily solved. Unfortunately your assertion that falling productivity is due to an inefficient labour market that requires reform is simply wrong. According to the World Economic Forum, the UK has one of the most efficient labour markets in the world (no. 5 out of 144):

    http://www3.weforum.org/docs/WEF_GlobalCompetitivenessReport_2012-13.pdf

    You should be looking at loss of output in high added-value sectors, failure of corporate investment, capital misallocation due to a severely damaged financial sector, and growth of low-pay, insecure and short-term working, for the explanation of falling productivity. ONS is helpful on this:

    http://www.ons.gov.uk/ons/dcp171766_283259.pdf

    and you may also find this report from the IFS useful:

    http://www.ifs.org.uk/budgets/gb2013/GB2013_Ch3.pdf

    It really is not helpful to misdiagnose the cause of a problem and therefore recommend the wrong solution, simply because you haven't bothered to do basic research. This material is not difficult to find.

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    Vuk Vukovic - About 2300 days ago

    I'm afraid you simply missed the point of the text, which was on the misinterpreted signals from the ratings downgrade. The "wrong" solution you imply was in fact the "right" one done in the examples mentioned in the text.

    As for the productivity puzzle, it was not stated how it should be solved in particular, but only in general (since the subject matter was something else).
    For the productivity puzzle I suggest you see here: http://im-an-economist.blogspot.com/2012/07/britains-productivity-conundrum.html

    It's more on the misplaced signaling done in the labour market making it less efficient.
    Btw, on the competitivness report you've attached, take a look at the 7th pillar for the UK (pg 359), and you can see some of the problems facing UK businesses regarding the labour market.
    In addition I recommend the reports from the British Chambers of Commerce, Federation of Small Businesses or CBI which all have reports based on survey data on what businesses find faulty on the labour market. These would be correlated to the ones you can find in the WEF competitivness report.

    These are some of the factors I meant when saying inefficient labour market.