Saturday, 26 March 2011

Credit rating agencies doubt Britain’s AAA rating – shock, horror.

Credit rating agencies: don’t you love them? They’re the folk who were giving all and sundry tip top ratings just weeks before the credit crunch hit. They are the people who Warren Buffet totally ignores.

The two agencies Moody’s and Fitch have recently expressed doubts about Britain’s AAA rating, which in turn will allegedly make it more expensive for Britain to borrow.

The flaws in this argument are as follows. (Incidentally, the arguments below are relevant to a country, like the UK, which issues its own currencies: the arguments are different for countries in common currency areas, like the Eurozone.)

The first reason for government borrowing.

Governments borrow for various reasons, but two reasons are of relevance here. First there is borrowing as a substitute for tax. That is, if government collects less in tax than it spends, it normally has to make up the difference by borrowing. (Incidentally, the AMOUNT such a government needs to borrow will almost certainly be nowhere near the tax shortfall. It may be more, or it may be less. Any idea that the two DO need to be equal is to apply micro economic, or bookkeeping ideas to a macroeconomic entity: government. But that’s a point I won’t dwell on here.)

Anyway, the purpose of this borrowing by the government of country X is to bring about a deflationary effect which cancels out the stimulatory effect of the tax shortfall. That being the case, what is the use of borrowing from abroad? Reducing the spending power of entities (households and firms) outside country X will not have much effect on the amount such entities spend INSIDE country X. In contrast, reducing the spending power of DOMESTIC entities WILL significantly reduce their spending inside country X.

In other words to cut down on the amount spent by entities in country X, money must be borrowed from those domestic entities: borrowing from those entities tends to cut down on the money they have available to spend inside the country X.

So in this scenario, if foreigners fail to lend to country X (contrary to the claims of credit rating agencies) no harm is done!

As to reluctance by DOMESTIC lenders to lend to a government, what of it? Such a government, if it cannot persuade domestic lenders to lend, can just grab money off its population by force: it’s called TAX. Perhaps the rating agencies haven’t heard about tax.

The second reason for borrowing: stimulus.

A second reason for government borrowing is the well known Keynsian “borrow and spend” policy which allegedly brings stimulus. But there is a problem here: crowding out. That is, the fact of borrowing tends to raise interest rates, which in turn discourages private sector economic activity.

So what do governments do to prevent any such “discouragement”? They buy back government bonds with a view to making sure interest rates DO NOT rise. Indeed, where stimulus is required, such a government is likely to buy back MORE bonds than are needed simply to prevent interest rates rising: the government is likely to buy back enough bonds to actually get interest rates to FALL.

In short, “borrow and spend” is a bit of a farce: the beneficial effect of “borrow and spend”, to a significant extent, actually comes from having the “government / central bank machine” PRINT money and spend it!

Now what do foreign lenders have to do with this? They are completely irrelevant! That is, if government X wants to create new money and spend it, then as far as that government is concerned, foreign and domestic lenders can go hang.

Having said that the stimulatory effect of “borrow and spend” to some extent comes from the creation of new money, it should of course be said that those who think crowding out is a minor problem claim that the stimulatory effect comes from “borrow and spend” per se. Well now, to the extent that this is true, what difference does it make whether the government borrows from domestic sources or from abroad? If foreigners are not willing to lend, government X can raise interest rates and borrow a bit more from domestic sources.

And according to the “crowding out isn’t a problem” brigade, the deflationary effect of any such interest rate increase is more than outweighed by the stimulatory effect of having government spend the money it has borrowed. Personally I find that unrealistic, but never mind. The important point is that whatever assumptions are made about crowding out, foreign lenders are irrelevant.

Does borrowing from abroad have no effect at all?

Having poured cold water on the idea that any particular country needs to borrow from abroad, this is not to say that borrowing from abroad as a substitute for borrowing from domestic sources has no effect at all. It has a significant effect on living standards in country X. That is, borrowing from abroad will temporarily raise the value of the country X’s currency on the foreign exchange markets.

It is always dangerous to extrapolate from the micro economic to the macroeconomic, but in this case the effect of a country borrowing from abroad is very similar to the effect of a household borrowing. The effect is a temporary rise in living standards: that is, the day of reckoning is delayed. Sooner or later, the loan must be repaid, and when it is, it hurts. That is, during the repayment process, there is a dip in living standards which (ignoring interest payments and inflation) will be equal to the above mentioned temporary boost to living standards.


For the government of a country that issues its own currency, the willingness of potential lenders, foreign or domestic to lend to it, is well nigh irrelevant.

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