By Michael Burke
The French and British authorities are engaged in a war of words over which country will be first to be downgraded by the credit ratings agencies. At least the hostilities are purely verbal - these ‘heroes’ of Tripoli are prepared to use other methods when the odds are overwhelmingly in their favour.
The immediate cause of the dispute was initially the remarks of French central bank governor Noyer. In response to the threat from Standard & Poor’s (S&P), one of the credit ratings agencies, that France would be downgraded, he argued that Britain should be downgraded first because its economic fundamentals are worse than those of France.
The remarks caused predictable uproar in Britain. Even the leadership of the LibDems, the main representatives of the pro-EU business class in Britain discovered its nationalist roots and criticised the remarks. But Noyer argued that, ‘they [S&P] should start by downgrading Britain which has more deficits, as much debt, more inflation, less growth than us and where credit is slumping’. Essentially, Noyer is correct on the relative ‘fundamentals’. But this focus on the ‘fundamentals’ also demonstrates a shared and thorough misunderstanding of the nature of the crisis.
The table below shows the relative levels for each of the indicators specified by Noyer. The estimates are taken from the EU Commission Autumn forecasts.
It is clear that the Noyer observations are correct. The British government’s credit rating is also under threat as the economy weakens. Yet France’s downgrade seems likely to happen even sooner. More importantly, the French government is currently paying over one per cent more for 10 year government debt than the UK so that its effective market rating is already lower than Britain’s. This is despite the lower deficit, lower inflation and higher growth in France.
This demonstrates that Noyer is looking in the wrong place for the determinants of bond yields. Bond yields are not primarily determined by the nominal level even of important economic variables. Ultimately the price of any given financial market asset is determined by the real level of savings that are directed towards it. In countries such as Britain, the US and Japan the very high level of corporate savings must ultimately be held in some financial asset, and in the current circumstances of weak or stagnant growth government bonds have looked far more attractive than their only main alternative, which is stocks. 10 year debt yields are currently below 2% in the US and below 1% in Japan. This is true even though government debt and deficit levels are even higher in the US and Japan than either France or Britain. UK companies cannot invest in financial instruments in another currency without exposing themselves to exchange rate risk.
For investors in French government bonds the situation is different. There is an easy alternative - German government bonds also denominated in Euros. The rising premium on French yields represents the increased perceived risk of the Euro breaking up, in which case investors prefer to hold the debt of the strongest economy in the Euro Area.
The key relevant ‘fundamental’ for the Eurozone is that investors may choose between different governments’ credits. That is, there is a market mechanism for redirecting savings towards one country - and there is no fiscal mechanism to transfer savings in the opposite direction. Just as in other Eurozone economies, bond yields started to rise in France as soon as ‘austerity’ measures were introduced. Investors based in the Euro have greater prospects of being repaid if they invest in government bonds where the economy will grow, not stagnate or decline.
French and British Both Wrong
The growth outlook is sharply deteriorating in both France and Britain. In the Spring Forecast the EU Commission was projecting 2% growth for both Britain and France in 2012. In the Autumn Forecast the Commission is forecasting just 0.6% growth. Both governments are pursuing ‘austerity’ policies which are clearly not working.
They have both also invested an enormous political capital in the maintenance of the AAA rating for their government debt and argued that their policies would reduce their budget deficits. As we have seen, both governments debt ratings are likely to be downgraded in 2012. And both countries are projected to have a deficit in 2013 which, five years after the recession began, is still double the level it was in 2007, before downturn began.
The failure of their policies has led not to a re-think, but in both cases to blaming foreigners. The unwillingness to correct a failed policy is the cause of the diversionary war of words between the two governments.
The most ridiculous aspect of their policy is that both governments claim that their policy is driven by the demands of financial markets. Yet the government bond markets are sending a very clear signal. Long-term interest rates are either at the current inflation rate as in France, or below it in Britain. They are so low because businesses are saving, not investing. Businesses feel more confident lending to the government than investing on their own account. But both governments insist on cutting spending. If that leads to renewed recession the effect will be to cut further the level of savings in the economy - and bond yields may start to rise.
Corporate savings are being lent to the governments at exceptionally low interest rates. This glut of corporate savings could be used to invest for recovery. Since businesses themselves refuse to do this, only the state can end the company investment strike.