Standard and Poor’s on Thursday, May 21 2009, issued the following statement: “Standard and Poor’s has revised the outlook on the United Kingdom to negative from stable. — The AAA’ long-term and A-1+’ short-term sovereign credit ratings were affirmed. — The outlook revision is based on our view that, even factoring in further fiscal tightening, the U.K.’s net general government debt burden may approach 100% of GDP and remain near that level in the medium term. ”
Is this good news for the UK or bad news? Both the UK’s long-term sovereign credit rating (reflecting the probability of sovereign default in the medium and long term) and its short-term sovereign credit rating (reflecting the probability of sovereign default during the next year) remain at the highest possible levels, AAA and A-1+ respectively. However, the negative outlook is bad, even if it is not bad news. Based on past behaviour, there is a one-in-three chance of a sovereign moving from a negative outlook to a one-notch downgrade.
The fact that one of the three leading credit agencies is publicly hinting at less than complete confidence in the solvency of the British sovereign is not in and of itself terribly significant any longer. Following their incompetent and deeply conflicted performance in rating structured products, the credibility of the rating agencies is badly impaired even in those domains – sovereign debt and the debt of large corporates – where they have not made complete asses of themselves.
Even though the credibility and reputation of the rating agencies is in tatters, the fact that they have not yet been written out of the regulations and rule books governing the investment behaviour of many institutional investors means that a downgrade would still affect market demand for UK sovereign debt. This will probably raise the funding cost of the UK sovereign somewhat.
But even without the input from the rating agencies, it would have been clear that the UK is about to exit its AAA status. It shares this fate with most of the other G7 countries. In two or three years, Canada may be the only G7 country left to have an AAA rating. France could conceivably join Canada. There is nothing too shocking about this. Not that long ago, Japan’s sovereign rating was on a par with Botswana’s (I thought that was rather unfair on Botswana).
I will expand on the case of the UK in what follows, saving a more detailed consideration of the US fiscal predicament (which is much worse than that of the UK) for a future post.
Sovereign debt is serviced out of future primary (non-interest) general government budget surpluses. More interestingly, non-monetary sovereign debt held outside the central bank is serviced out of the future primary budget surpluses of the consolidated general government and central bank and out of the future revenues from new base money creation (seigniorage) by the central bank. I’ll refer to the non-monetary debt of the consolidated general government and central bank as state debt. Think of the state as the consolidated UK Treasury and Bank of England in the UK and as the consolidated US Federal Treasury and the Fed in the US. State and local debt and budget deficits in the US either are a side show or are taken over by the Federal government if push comes to shove (watch California externalise its state debt during the coming months).
UK state debt is expected to rise from just over 50 percent of annual GDP today to over 100 percent of GDP in four or five years time. With deficits of 12 percent of GDP or higher very likely during the next couple of years, there needs to be a decent recovery by the end of the 2010 for the debt burden not to rise even faster. Net interest payments on the public debt (currently a low 1.83 percent of GDP – an average effective interest rate of 3.6 percent) will double even if interest rates remain at their extremely low current levels, something I consider unlikely.
During the decade preceding the crisis, tax revenues were flattered increasingly by the unsustainable housing boom and the profit and income explosion in the financial sector. Such easy revenue pickings are unlikely to be forthcoming in the future, even if the economy recovers as hoped by all and expected by a few.
It is likely that the path of potential output in the UK will turn out to be lower because of the crisis. The UK Treasury estimates that a combination of a permanently higher cost of capital and a reduction in the effective supply of labour (due to lower net immigration and hysteresis’ effects from higher unemployment) will knock five percent off the level of the path of potential output.
Let’s assume that (non-monetary) state debt-to-GDP ratio in the UK doubles over the next 4 or 5 years and that the path of potential output is five percentage point below its old level, even if the growth rate of potential output is not permanently affected. What will the higher debt-to-GDP ratio do to the average effective interest rate paid on the public debt? Obviously it will rise. The real rate of return required on the public debt will rise because sovereign default risk is higher when the debt to GDP ratio is 100 percent than when it is 50 percent. There is also a risk of higher inflation if the government decides that rather than defaulting outright and formally on its debt, it prefers to reduce the real value of its nominal debt through higher inflation. An unanticipated increase in inflation will permit a de-facto amortisation of the debt in real terms, even if we allow for the effect of inflation expectations on nominal interest rates for newly issued debt. The longer the maturity of the outstanding fixed-rate nominal debt, the more effective an unexpected increase in inflation is in reducing the real value of the public (and private) debt.
Let’s assume, conservatively, that a doubling of the debt-to-GDP ratio from 50 to 100 percent raises the required real rate of interest by one percentage point.
The permanent primary surplus (as a share of GDP), p, the permanent seigniorage (as a share of GDP), s, the state debt (as a share of GDP), b, the long-term real interest rate, r, and the long-term growth rate of real GDP, g) can be used to write the solvency constraint of the state as follows:
p + s ≥ (r – g)b (1)
Permanent means roughly ‘long-run future average’. UK long-term real sovereign interest rates (20 years maturity or over yields on index-linked debt) are around one percent today. The long-run growth rate of real GDP is probably somewhere between 2.25 percent and 2.50 percent per annum. Bingo! The UK government lives in Ponzi land: with the growth rate of GDP (roughly the growth rate of the tax base) higher than the interest rate on the public debt forever, the government can always service its outstanding debt by issuing more debt. Primary surpluses, or monetary financing are never required. Bernie Madoff, come home, all is forgiven.
Sure, in the current recession, GDP growth is negative so the current real interest rate on the public debt rt exceeds the current growth rate of real GDP, gt but solvency is not about cyclical relations between growth rates, interest rates, primary surpluses and seigniorage revenues, but about their long-term secular values. As long as r < g , any value of the public debt-to-GDP ratio is consistent with non-inflationary state solvency.
Therefore, to worry about the solvency of the UK sovereign, or about the inflationary implications of current and prospective budget deficits, you have to believe that the current values of the real yields recorded on long-dated index-linked government debt understate the like actual future real rates the government will have to pay, and/or that the growth rate of real GDP will be lower in the future than it has been in the past couple of decades.
I believe that ex-ante global risk-free long-term real interest rates are likely to rise in the next few years and are likely to stay at their new higher levels, of around three percent per annum for the foreseeable future. I base this on my belief that the ex-ante global saving glut is likely to be over soon, as China, the other BRICS and the GCC states boost domestic demand and reduce their private and public saving rates, without a fully offsetting increase in the planned savings of the advanced industrial countries. Real GDP growth is also likely to be lower than the rate recorded in the past decade, if only because much of the increase in the value added of the UK financial sector over the past decade was illusory. Assume long-run real GDP growth declines slightly to 2.25 percent per annum.
We are now out of Madovia and in the land of fiscal scarcity. With r = 0.03, g = 0.025 and b = 1.00, the UK state has to generate a permanent primary surplus plus seigniorage equal to at least 0.75 percent of GDP for the state to remain solvent. If market nerves put a default risk premium of 100 basis points on top of the risk-free rate, the required permanent primary surplus plus seigniorage becomes 1.75 percent of GDP.
This may not seem like much of a challenge, until you compare it with the current and near-future primary surpluses the government is likely to run. Non-inflationary seigniorage, under conditions of normal time preference is tiny in the UK, not more than 0.25 percent of GDP – often much less. The stock of coin ad currency is barely 4 percent of annual GDP. Bank reserves with the Bank of England have recently shot up to about £71 billion (around 5 percent of annual GDP), but since most reserves pay interest, no significant interest is earned on them. Let’s be optimistic, and argue that the UK state has to run a permanent primary surplus of 1.5 percent of GDP.
As the government deficit explodes over the next few years, the actual primary surplus is likely to be primary deficit of around 8 or 9 percent of GDP. As the economy recovers, tax receipts will rise and cyclical public expenditure will decline, but the rest of the public expenditure programme (health, education, pensions) will keep on rising in real terms and as a share of GDP. It is easily conceivable that when the output gap is closed again, in 4 or 5 years time, there will still be a primary deficit of five or six percent of GDP. That means that a permanent reduction in the primary deficit will be is required of between 6.5 and 7.5 percent of GDP.
Such a permanent fiscal correction (tax increase or cut in public spending) is politically difficult. In the US, it would be impossible, given the paralysed state of its political institutions. The UK, with its elected dictatorship (effectively unicameral, first-past-the post system, no independent domestic judiciary capable of constraining the executive, no other formal checks and balances), may be able to impose the savage spending cuts or thumping tax increases that will be required to restore solvency without inflating the public debt away.
But the risk that the UK will choose the inflationary route is non-zero. These odds have increases because of the reluctance of the authorities to issue additional index-linked debt. The only credible commitment a government can make that it will not try to inflate its debt away in the future, is to issue only index-linked debt and indeed to retire all nominally denominated debt and replace it with index-linked debt. Neither the British nor the US authorities show any sign of doing so. In fact the opposite is the case. This reluctance to issue index-linked debt is consistent with a policy of keeping the inflation option open.
Clearly, aggressive inflationary monetisation of the public debt, or a refusal to let the central bank reverse the monetisation that has already taken place, when the economy recovers, the output gap closes and liquidity preference comes down from its current extraordinary levels, are inconsistent with central bank independence. In the US, this would present no serious problem. The Fed is the least independent of the leading central banks. I believe Bernanke takes price stability seriously and would resign rather than accept responsibility for a high inflation strategy forced on the Fed by the Treasury. With Larry Summers waiting in the wings to be the next Chairman of the Fed, however, the solvency-through-inflation route would be wide open.
For the UK, the choice of the solvency-through-inflation option would require that the Treasury invokes its reserve powers, granted in the Bank of England Act 1998 and retained since then. This permits the Treasury to take back from the Monetary Policy Committee of the Bank of England, the power to set interest rates and conduct monetary policy generally. Should that happen, the inflationary consequences would be immediate – through a collapse of Sterling. I consider this outcome unlikely, but not impossible – and more likely that a ‘tail event’.