GIVEN George Osborne’s failure to cut spending enough, his wrong-headed decision to rely primarily on tax hikes during the first years of his austerity plan and his inability to push through growth-enhancing reforms, the UK’s loss of its AAA rating had long become inevitable. The rating agencies have made lots of silly calls in the past but not this time – nobody seriously believes that Moody’s was wrong to act on Friday, though it should probably have done so a few months ago when it finally became clear that the coalition had no interest in taking dramatic action to boost competitiveness.
The stark reality is that the UK is a busted flush: the deficit is increasing again, despite accounting shenanigans, and is being financed through quantitative easing in a dangerous game of financial pass the parcel; an army of zombie firms remain addicted to near-zero interest rates, forcing down productivity and preventing a Schumpeterian process of creative destruction and reallocation of capital and labour; the banking system remains squeezed; and the economy remains tied down by regulations, outdated planning laws and high tax.
Needless to say, it is hardly all this government’s fault: it inherited an abysmal situation from Gordon Brown and the UK economy has also suffered a great deal from the recession in the Eurozone and elsewhere. But the government has been in power for over two and a half years and it should have achieved more by now. Yet if the coalition doesn’t have the answers, neither does Labour: it still believes that spending a little bit more than the coalition, and increasing the national debt even further, will save the UK. Such a course of action would truly end in disaster.
So what now? It is hard to predict exactly what the downgrade’s impact on sterling and gilts will be over the next few weeks. There are always many variables at play. Many investors had already priced in the downgrade. The Bank of England is intervening in the gilts market via quantitative easing (QE); that, more than any other factor, is the real reason why gilt yields remained so low so long, though they have spiked recently. Relative performance matters: the Italian election could be sterling and gilts’ biggest drivers over the next couple of days. But there is no doubt that sterling, down five per cent already on a trade-weighted basis this year, will face renewed, prolonged pressure. This will hike the price of imported goods, feed inflation, further erode households’ purchasing power and depress demand.
Gilt yields – the interest rates on the state’s IOUs – are equally complex prices. They depend on many things – supply and demand, the expected risk of default (zero, in the UK’s case as it can print the money), expected inflation and the expected long-run performance of the economy. It is hard to disentangle these effects. The prospect of more QE will probably prevent yields from rising too much for the time being, as will the growing view that Britain’s long-run growth rate will remain low. But both of these will further depress sterling.
The real problem, as HSBC’s currency team, led by David Bloom, noted last night, is that markets “expected [Osborne’s] plan to succeed and sterling was supported accordingly, but growth continues to disappoint and the fiscal numbers are coming in shy …for the market, the downgrade will underline that their earlier belief in the plan has proven wide of the mark. Part of the re-pricing of sterling that this reappraisal implies is already underway. There is more to come.” It’s starting to look as grim for the pound as it is for George Osborne.
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