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Why Moody’s downgrade of UK sovereign debt is meaningless

By Marc Chandler

Moody’s took away the UK’s triple A rating late Friday. A ratings downgrade has long been rumored, and although the timing is always surprising, the move itself has long been anticipated. Sterling slumped on the news in thin dealings, losing a cent in about 30 minutes.

When it comes to corporate ratings we can appreciate that rating agencies may have access to private information. They may also be of value in some developing countries, where information is more difficult to secure. However, when it comes to large developed countries, the rating agencies have access only to public information and it is the same information that investors use to make their decisions.

That there is extremely little value-added or new information contained in a rating agency is evident in the lack of market response to downgrades of Japan, the US, Austria, and France, for example. There is little reason to expect the UK to be an exception to the rule.

Some observers are claiming the loss of the UK’s AAA rating is a serious blow to the UK government, but we are less convinced. It is true that UK Prime Minister Cameron and Chancellor of the Exchequer Osborne had hoped its efforts to address the UK’s debt and deficit would have averted a downgrade. The downgrade is not going to deter them from the austerity path upon which they have embarked. 

It is politically naive to think see the downgrade as some opportunity for them to change course. They have rejected the IMF’s calls to slow the austerity drive. What they did not surrender to the IMF, they will not yield to Moody’s or the government’s critics who what to use the downgrade to bludgeon the government into accepting its critic’s, including the Labour Party’s agenda.  

Reviewing the rationale behind Moody’s decision is like understanding a set of economists’ views. It is a narrative constructed around well known facts. The global economic weakness, especially in the euro area, and the “ongoing domestic public- and private-sector de-leveraging process” is generating poor growth in the UK and this may persist, Moody’s says into the second half of the decade.  

The weaker growth means that the debt/GDP ratio will remain elevated for longer. Moody’s doesn’t expect it to peak until 2016. The slower growth and higher debt ratio, in turn, means that the UK’s ability to absorb additional future shocks is more limited. 

Most investors will find nothing new in that assessment. Ironically, Moody’s demonstrated its firm grasp of the obvious the same day that the EU provided updated its forecasts. It expects the UK economy to expand by 0.9% this year, compared with a 0.3% contraction in the euro zone, which incidentally absorbs 40% of the UK’s exports.

Lost in the initial reaction by many observers who wrung their hands at the downgrade, Moody’s reverted back to a stable outlook for UK debt and the rationale appears to also be shared by many investors. Simply, even if crudely put, the UK is not Greece. It has a highly diversified economy and strong institutions. It has a favorable debt structure. The average maturity of its debt at 15 years is the highest among the highly rated sovereigns. Its debt servicing capacity remains very strong.

Indeed, reading between the lines of Moody’s assessment suggests that, arguably, if UK government were to dilute its efforts to address the country’s debt and deficits, Moody’s may not have been so inclined to offer a stable outlook.

From a policy point of view, Cameron’s commitment to austerity is taken as given, then any change must come through two other channels: monetary policy and the currency. We learned in recent days that BOE Governor King was out-voted for the fourth time in his tenure. He wanted to resume gilt purchases. As has often been the case, he will likely get what he wants. When Carney takes the helm in July, he also may be inclined to ease policy and it will be interesting to see if he is as tolerant of being outvoted.

Sterling has fallen 6.7% against the dollar, second among the major currencies to the yen which has lost 7.1% year-to-date. It has declined about 6% on the BOE’s broad trade-weighted measure. Just like the difference between expansion of the Federal Reserve’s balance sheet relative to the BOE’s balance sheet cannot explain this decline in sterling, so too sterling’s decline may not boost exports as much as some, especially those who have focused on currencies wars, would suspect.

There are several reasons for this counter-intuitive assertion. First, surely we can all agree that foreign demand is important. As we have noted, a major market for UK goods, the euro area, is expected to contract this year. The US is also expected to slow from near 2% pace it has averaged since the economy bottomed nearly four years ago.

Second, the restructuring of the UK’s financial sector and the changes in the globally, may curb its ability to export financial services. Third, for many goods, there are important non-price dimensions to competitiveness, such a quality, design, speed of service, which will not be impacted by sterling’s decline.

What this all means is that the UK’s exports may be sufficiently sensitive to sterling’s exchange rate to allow exports to replace the domestic aggregate demand being squeezed by the de-leveraging of the government and households.

From an investment point of view, we prefer UK equities over bonds. The FTSE 100 has a dividend yield of 3.7%, while the 10-year bond yields about 2.1% Sterling’s broad trade-weighted index is the most inversely correlated to the FTSE 100 since early 2007 near -0.44 on a 60-day rolling basis using percent change. Running the correlation on simply the level of the FTSE 100 and the trade-weighted index is near 0.93, the highest since late-2004. The sterling-dollar rate is (on a 60-day percent basis) about 0.71 correlated with the trade weighted measure.

Marc Chandler

About 

Marc Chandler joined Brown Brothers Harriman in October 2005 as the global head of currency strategy. Previously he was the chief currency strategist for HSBC Bank USA and Mellon Bank. In addition to frequently providing insight into the developments of the day to newspapers and news wires, Chandler's essays have been published in the Financial Times, Barron's, Euromoney, Corporate Finance, and Foreign Affairs. Marc appears often on business television and is a regular guest on CNBC and writes a blog called Marc to Market. Follow him on twitter.

1 Comment

  1. Linus Huber says:

    I still am able to remember certain events taking place during my childhood and value those episodes, simply due to the fact that they stayed in my memory like for ever and, therefore, they must have made a great impression onto my still developing personality. It is not a matter of assessing those experiences in themselves but to consider their significance in how they influenced my future conduct as adult. It also explains the notion that changes in the individual’s behaviour take place in a very slow motion as we were exposed to past principles during the years when our personality was formed.

    Monday was the most important work day in my father’s working life. Furnished with a substantial amount of cash he went early morning between 3 and 5 a.m. on his way to collect all those calves he purchased the previous week by driving from farmstead to farmstead in order arrive with the fully loaded truck at the marketplace by latest 8 a.m. As earlier as better, as the purchasing agents of slaughter houses and feeding operators may otherwise have covered their needs already. Of course, his long experience and net work was helpful to him, nevertheless, a minor doubt seemed to always remain, as he had to work hard to arrive at the present situation in his life when he dared the first step into independence after having worked as a simply employee at the train station where, beyond other duties, he was assigned to attend the station’s large weighing scale and consequently was able to establish some contacts within and knowledge of the cattle trade. He was fully aware that the wellbeing of his 6 children and wife at home depended on his success. His irregular anxiety attacks during the prior evening often produced a relentless itching sensation on the bottom of his feet and he treated those symptoms with the rigorous employment of a rather rough cloth-brush.

    These episodes signify the fact that risk taking can produce a great deal of stress and is quite an unpleasant experience for an individual. However, the question we have to ask ourselves is whether such experiences prove to have a positive longterm effect on the individual person as well as on society at large or whether we should try to prevent such occurrence (e.g. by issuing a government program that guarantees the purchase of all cattle reaching the market). Although the individual detests stress, different studies prove that stress changes the individual’s behaviour in as far as the individual strives to reduce risk which will enhance the values of sustainability, responsibility and accountability. In addition, it is a rather questionable theory that when we redistribute risk to the public domain that the individual person will experience less stress as his attention will shift to other areas of potential sources of stress. In actuality, it is human nature that requires and is looking for challenges as we otherwise will suffer a slow death. This aspect is best demonstrated by the fact that people exposed to a life-changing experiences, e.g. end of one’s career or the death of one’s partner, often fall into a sluggish, dull and depressive state as the stimulating effects of challenges and stress are lacking. In other words, the anguish experienced due to a risky and challenging situation produces in itself a positive outcome for the individual person.

    The next question, we should ask ourselves, considers the effect on society when the insecurities are reduced from the individual and therefore the costs of such measures redistributed to society at large and how this will effect the individual’s behaviour in such a society. It is hardly refutable that the above listed qualities of risk-averse behaviour (sustainability, responsibility, accountability) will be effected in the opposite direction. The knowledge of such reflexivity is much better developed in scientists than in today’s economists as they are much better equipped to evaluate the impact of manipulative action on a living organism as compared to a mainly mathematical approach taken by economists that emphasises mechanical and physical attributes. To further the comprehension for the word “reflexivity”, let me use an example that fits well into our time period.

    I seldom am sick, however, whenever an non-life-threatening illness befalls me, I will investigate the potential sources of the symptoms in the internet on my own. In my own capacity, I evaluate the most probable cause of my discomfort and consult people close to me for further advice. Thereafter, I make my own decision on how to treat the sickness, which often means that I simply do nothing and let the body do its job while it is trained to increase its capacity of resistance at the same time. At other times I will visit a trusted pharmacist, discuss the best and most cost-effective medication for the purpose, administer it and the matter has been brought to its conclusion. Of course, unforeseen difficulties may arise, but this is possible as well, when I use the advice of a trained medical doctor. However, the the important aspect of this example lays in the fact that I take full responsibility, assuming the full risk, instead of delegating it. Unfortunately, this procedure of dealing with one’s minor illnesses is not possible in most Western countries, as the health insurance will reject any costs occurred from such behaviour and/or the medication will not be available without a prescription by a approved practitioner of the medical profession. Under the circumstances that the individual would be forced to cover medical expenses from his own pocket (no health insurance), the number of visits to the physicians office may drop by 50% and result in a major reduction in this increasing share of economic activity as well as increase sustainability and personal responsibility. I, therefore, can conclude that the present system produces the wrong incentives by delegating self-reliance and risk to the grey area of the general public and the rules therefore undermine the sustainability of the system as a whole, a fact that produces negative consequences for society. The example is not chosen to criticise present health policies but simply to show the longterm effects on the individual’s behaviour and to demonstrate the meaning of reflexivity. Just as an aside, I did not even mention the enormous administrative costs that arise from a managed system.

    “He never cashed in his cheque” were my father’s words. I was unable to recognise whether he considered this to be a delightful or dissatisfying fact as the sound of those spoken words projected a sense of apprehensiveness. Shortly prior to this day, my father was involved in a court case in which the seller of some pigs filed a lawsuit. After having sold those pigs to my father concluding the deal with a handshake and after the completion delivery, the seller felt the agreed price too low and felt cheated, resulting in him taking legal action. In the cattle trade it was/is a common feature to seal a deal with a handshake without the use of any documentation. The seller lost his case in the court and had to pay for the costs of the court proceedings of both parties. The original payment in the form of a cheque, however, never took place as the seller did not present the cheque to the bank. After some deliberation I concluded that the seller’s lack of claiming his dues must have been the result of one of the following reasonings. Perhaps, during a burst of temper, he tore the cheque into pieces and was now too proud to ask for a newly issued cheque. Maybe, the seller believed that he did not have the right to claim payment as part of the court’s decision in that this represented part of the punishment in his eyes. Perhaps, he wanted to demonstrate his disdain by refusing any payment from a contemptible person as my father must have appeared to him by that time. Whatever the reason might have been, all of them show a deeply rooted sense of personal responsibility and concomitant respectability. The court must have arrived at the conclusion that my father did not deceive the seller and the deal, therefore, was valid. In consequence, the seller was forced to scrutinise his own honesty and probably felt embarrassed and accused of dishonourable conduct. When comparing this behavioural pattern with today’s commonly applied conduct we certainly are able to recognise a change in the behavioural model. Honour, respectability, tradition and honesty have lost in weight in today’s world where often nothing but the figure on the bottom line counts. The ease of commerce, that depended on mutual trust, has been replaced by countless clauses and provisions based on an extensive regulatory frame work. Within this context, we now should ask ourselves whether, under the present development of increasing regulation, we arrived at a more just, honest and rule of law observing environment in our society or whether the feeling of real justice (not formal law observance) and legal certainty has been undermined. I do not want to rate the changes but simply state that, under the influence of the numerous regulatory measures, personal responsibility and values like honour and respectability have declined. Respectable and responsible behaviour cannot be decreed by laws but are human values that define us as humans. As more and more aspects of social interaction are regulated, the more the human’s inherent need of respectability and personal responsibility is reduced as those aspects of ensuring a coherent social order have been delegated to the rule makers. This represents another example of reflexivity.

    In the attempt to reduce the risk of the individual member of society, we have created many systems and regulations. The management and enforcement of these rules take a huge administrative effort and we created or expanded corresponding institutions. Like society, an institution is better regarded as a living organism and one should avoid to view them simply in terms of their function. From nature we know that an organism tries to grow and, when under attack, will defend itself. It is rather easy to comprehend this aspect as it is obvious that each employee within such an organisation will act to enhance his job security by expanding his/her sphere of influence. It is a normal human behaviour and should be considered a positive trait in itself. However, this behaviour of an institution’s members may entail negative implications for society at large in its interaction with the increasing size of the regulatory frame work. It acts like a booster to the above development and more and more rules become institutionalised resulting in reduced flexibility and sustainability of the overall system in the long term. The idea to eliminate every risk by centrally planned measures produces increasingly difficulties with sustainability and vitality for the whole system. With the reduction of personal liberty, qualities like self reliance, personal responsibility, accountability, community spirit, empathy, respectability and many other important values for a well functioning society are weakened. Those human qualities are replaced by the struggle to influence the rules themselves and to find ways to profit from existing rules and this simply due to the fact that we have delegated the responsibility for a smoothly functioning social order away from the individual. Honourable and respectable behaviour has lost its importance and simply the rules decide. Those who feel disadvantaged by the rules, try to change them in their favour (generally an option reserved for the elite) or, like probably the most of us, fall into a state of resignation. For economic reasons rules and laws are increasingly irrelevant (bending or disregard of constitutional law and reinterpretation of laws that violate the spirit they were written in) to the decision makers as they project the seemingly overwhelming important task of saving the system, while ignoring the fact that the system is damaged by exactly those actions of increased arbitrariness and insecurity that may inflict much larger wounds to the fabric of society than a temporary set-back in economic growth.

    “This is a real man” my father exclaimed when the buyer of my, due to an motorcycle accident, recently deceased brother’s apartment in Zürich paid with a bundle of bills in cash. I was no more a child but still the sound and dynamics of those spoken words were filled with conviction and produced an lasting imprint on me. It was not simply the fact that my father admired the buyers ability to pay in cash but an air of respectability was transferred to the buyer. There are numerous sayings that glorify the meaning of cash money. My father’s perspective, as well as the viewpoint of many others of his generation, was probably formed in the difficult years after 1929 and he stuck to his conviction even in view of empirical evidence that proved the incorrectness of that notion since the middle of the last century at the very least since money in whatever form including cash lost purchasing power, no matter what currency one looks at. It represents a behavioural pattern that has been etched on his mind for good.

    Most people of that generation are probably not alive anymore today or have hardly any direct influence on today’s events. When discussing the matter of money with young people, I often get an unambiguous reply that I do not have a clue about the meaning of money in today’s world and that a currency’s function is simply a means for payment. Numerous economists have developed abstruse ideas and theories as well and sneer at the idea of sound money. It was in 2001, when I purchased a new vehicle in Singapore (due to high taxes a rather expensive endeavour) and when, after completion of negotiations, I explained that I plan to pay in cash and therefore an additional cash-payment discount should apply, the salesman was close to cancelling the agreed transaction. The reason for this notion was the fact that the salesman was counting on earning an additional commission when getting a credit agreement signed which in my case did obviously cease to apply. At that time already, I was wondering what type of implication this kind of incentive system will take on social values and which kind of values will be promoted as well as which ones weakened as a consequence. The value system of a society can never be contemplated in isolation because when one type of value increases some other value must lose in degree of relative importance. It can never be a moot objective to investigate the origins of changes in society’s value scale.

    The power of suggestion plays an important role in the field of psychology for the purpose of changing the subject’s self-image. This insight is applied in the area of education as well as when raising a child in order to promote a desired mode of conduct. The behaviour of society at large as well as the individual’s behaviour within society can be modified over time in applying the same principle. Each law or regulation exerts an influence on at least two levels. In one way, the desired improvement in terms of quality of life is achieved for a part of the population and in another way, due to the adaptive capabilities of organisms, a minor change in one’s behavioural mode can be registered. The changed pattern of behaviour can itself be divided into two areas, namely into the area of the rules affecting the individual’s action directly and into the area where the new rules have an implied impact on the individual’s self-image as member of said society. As higher the regulatory density the lower will be the level of personal responsibility and accountability, self-reliance, honourable and respectful attitudes, individual freedom and other factors essential for a successful society.

    The effectiveness of a taken measure on the behavioural pattern of the individuals within a society is strongest when all members are subjected to the measure on a continuous basis to produce a maximum impact on the self-image. There hardly is any other system created by humans that outweighs its influence on people’s self-image and the social order to a greater degree than money. Money is omnipresent, used daily by everyone and everywhere, measures economical success and contributes decisive to the self-image of an individual. The influence of this medium on a currency area’s people is not limited to monetary and economic aspects only but, on the basis of its overwhelming relevance, affects the intangible values within the concerned society. The attributes of a currency that rests mainly on the monetary policies of the respective Central Bank, therefore are of enormous societal significance.

    Without exception, Central Banks the world over pursue a policy of currency devaluation. It actually is surprising that not even one exception to the rule exists and all of the currencies presently in use are devalued, especially when viewed from a longterm perspective. Some devalue faster others slower but all of them are subjected to debasement. Is this a natural phenomena and an inherent trait of a currency or is it man-made? Upon closer inspection we, of course, can detect that a deliberate manipulation takes place by sacrificing the currencies value for arriving at short term economically favourable outcomes. In other words, the property rights of the currency owner is violated in order to achieve a statistically measurable and therefore quantitative improvement of economic performance. Growth, however, is measurable in quantitative terms only unable to assess the quality of that growth (e.g. by evaluating factors of sustainability). It is not difficult to conclude that economic growth arrived at by manipulative monetary policy will produce negative results for society that are not directly measurable but, over time, will influence society in a negative way. Hereinafter I like to explain some of those negative consequences which should be evaluated in context with the above explanations of reflexivity to arrive at a comprehensive picture of the jigsaw puzzle.

    We just explained that the manipulation of currencies (persistent longterm devaluation) violates the property rights of the holders of currency. When the currency is devalued, the corresponding loss of purchasing power of the currency holder of let us say 20% in 10 years does not evaporate but someone else within the currency area has benefited correspondingly. In general, those net in-debted in currency terms reaped those benefits. It simply is a wealth transfer and society has been conditioned to consider this aspect in their behaviour as normal. The real result is an environment that enhances the volume of credit creation and benefits the financial sector as the net currency debtor benefits without corresponding effort and is able to register a profit, even after the deduction of the costs of the financial transaction. In spirit this situation does violate the property rights stated in most constitutions and consequently undermines the spirit of the rule of law.

    The partial expropriation of the currency holder’s purchasing power produces some additional side effects in that money turns to adopting more of the attributes attached to possessions than property. E.g. we can possess a car without being the owner of that car. This is best demonstrated when comparing a rented car to a car owned by the driver. Do we behave in exactly the same manner when the car is owned or rented? Some drivers may have those qualities and not act differently at all. Nevertheless, the sentiment of care and sustainable maintenance for a rented item are limited. Ownership does not simply has benefits but entails the obligation to take care of the item in question on a sustainable basis. When property rights are weakened, people are being conditioned over time to think in a short term and unsustainable way. When this way of thinking is practiced by a small number of the population only, the effect on society will probably be negligible. However, when on the basis of conditioning over many decades an ever increasing percentage of the population is changing their behaviour in the described direction, there will be damaging consequences for society in that short term thinking and unsustainable behaviour will be entrenched in the system.

    Another effect is the culture of immediate gratification that is expressed by the wish to possess an item today and now without saving first for it. One prefers to in-debt oneself than to exercise patience and forbearance and to budget responsibly. This development leads to a behaviour that undermines the value of sustainability. The concept that one has to first work hard to arrive at a certain level of living standard is weakened. However, living on credit, to use a popular expression, is promoted. Today and now is more important than the uncertain future that is no more calculable. The consumer and throw-away society is born.

    The behaviour toward risk changes also in that the risk increasingly is transferred away from the risk taker to society at large. This development did not start with the bail-outs in 2008 but reached its temporary climax in that eventful year. Such a constellation increases the preparedness to run high risks and undermines the virtue of diligence, a necessary requirement for sustainable development. The relief from negative consequences of risk taking undermines the virtuous values indispensable to a successful and free society like diligence, responsibility, accountability and honesty.

    As money will be worthless in the long run, people focus more on tangibles to escape the value deterioration of the currency. The idea to save your nest egg or for some future emergency in the form of a simple savings account is frowned upon and is being replaced by investments in tangible assets. This enhances a materialistic ideology in which ethical principles and other values important for a smoothly running society lose their significance. It feeds the notion of mistrust towards decision makers (no one likes to be manipulated) and produces tendencies of individualism with a reduction of empathy towards other members of society.

    The economic well-being of the population depends increasingly on growth that is based on the devaluation of the currency and the high power concentration with the monetary authorities is elevated to a degree that they must feel like pontiffs. Incrementally it becomes unavoidable to disguise the non-existent sustainability and the game of perception management starts. As the population clings to the status quo, the proclamations of the decision makers are desperately received and accepted with enthusiasm, although those claims are contradicting logical thoughts. Respectability, honesty, responsibility, accountability and sustainability are replaced by a culture of lies and deception.

    Another aspect of the reduction in property rights is the fact that actually theft is being legalised. The consequential undermining of the rule of law reduces the protection of personal freedom. Of course, some aspects of personal freedom must be limited, but outside the spectrum of those aspects, the rules of the state should mainly aim at protecting the personal freedom and consequently the associated personal responsibility and similar positive traits that enhance a smoothly functioning social order. I do place central banks to the functions of government despite the fact that they do enjoy formal independence. Each intervention, regulation and manipulation must be evaluated on its longterm effect on the value scale of society. These are not measurable aspects but qualitative values. As economists are trained in measurable changes, this kind of analysis that includes psychological effects is alien to them.

    In order to conclude my short essay, I would like to give you, dear reader, a way to remind yourself of the above contents: When you manipulate people like lab rats, do not wonder, when increasingly they will adopt the attributes of a rat (conditioning). Or in other words, who devalues money, devalues humaneness.