The moodiness of markets


Moody’s has released an ominous post-budget statement:

"Although the weaker economic growth prospects in 2011 and 2012 do not directly cast doubt on the UK's sovereign rating level, we believe that slower growth combined with weaker-than-expected fiscal consolidation could cause the UK's debt metrics to deteriorate to a point that would be inconsistent with a AAA rating."

The ratings agency has downgraded its forecast for British growth this from 2.0 percent to year to 1.6 percent. The government's independent Office for Budget Responsibility now forecasts growth at 1.7 percent. Slower economic growth will make it more difficult for the government to rein in its budget deficit, throwing its credit rating into further question.

How would Britain respond to the lowering of its credit rating? Such an event would be nothing short of a crisis. Interest payments on government debt would go up, which means we would be paying more to service the structural deficit. In order to pay the higher interest rates demanded by the bond market the government would have to cut more, increase taxation and/or increase borrowing. A worst-case scenario would put the UK in the same position as Greece, Portugal or Ireland. If this seems fanciful, it should be remembered that Britain has once before been forced to go cap in hand to the IMF.

Portugal’s Parliament has rejected austerity measures leading the Prime Minister’s resignation, so it appears imminent that there will be an IMF-European Stability Fund bailout. Standard & Poor’s has cut Portugal’s long-term credit rating from A- to BBB, following the country’s political crisis, bringing Portugal’s credit standing closer to junk status. Moody’s has already downgraded the Spanish banking sector, and the threat of contagion looms.

To avoid this type of crises the UK should engage in extensive pro-growth reforms, cutting regulation for small businesses, cutting corporation tax more quickly, abolishing the minimum wage and employer National Insurance contributions, cutting CGT, and much more. There is plenty that can be done to promote growth, but it should be done sooner rather than later.