THE past two years, as the credit bubble burst, have witnessed a turnaround in private sector debt accumulation and a reduction in the leverage in financial markets.
The process has been traumatic for many of the most highly exposed institutions (such as the banks) and has plunged the global economy into recession.
The earlier mood of despair has been alleviated by policy actions on interest rates, taxes and public spending and moves to recapitalise the banks and improve liquidity in the credit markets.
The hope is that these will allow the debt reduction process to be more manageable than in the tumultuous days of last autumn, by spreading the adjustment from immediate pressure on specific parts of the economy to longer-term liabilities of society as a whole.
Not surprisingly, this has caused resentment as many felt that those responsible for irresponsible lending (and borrowing) decisions should carry the can.
Despite the appeal of these arguments in principle, one is reminded of the character in the joke who, on being asked for directions, said: “Well, I wouldn’t start here”. If the consequence of taking no action had been to plunge the banking system into liquidation and, owing to the collapse in credit provision, to cause an economic depression, action to avert this disaster was justified.
However, this rescue has longer-term consequences, vividly highlighted last week by the news that one of the main credit rating agencies had placed the UK’s AAA credit rating on “negative watch” for a possible downgrade, owing to the prospective ballooning of the national debt.
It should be noted that the credit agencies did not cover themselves in glory during the boom, having failed to identify the credit risk in complex financial instruments that played a major part in the banking crisis. They also accorded Iceland a triple-A rating until last year.
Furthermore, the UK’s national debt was over 100% of GDP for decades after 1945, yet the country was able to fund its deficit. Japan lost its AAA credit rating many years ago, yet its bond yields are the lowest in the world.
However, a rating downgrade would matter. First, because the projections of the national debt do not include the hidden costs of the public sector’s pension liabilities. Second, because the absence of exchange controls means that capital is freer than before to flee countries with poorer credit ratings. And thirdly, because our trade deficit means we depend upon foreign capital inflows.
Although a return to economic growth will help to rein in the deficit, it will be hard for the UK economy to grow as fast as it has over the past 25 years. The deficit will have to be reduced, either through conventional disciplines such as spending cuts or tax increases or covertly by inflation being allowed to rise, eroding the value of the debt. The message for investors is to diversify geographically, to make use of available tax concessions (such as ISAs and pension savings) and to ensure a degree of protection from inflation risks by investing in inflation-protected bonds and real assets such as equities.
Those who lost most in the 1970s inflation were people who invested in investments regarded as “safe”, such as government bonds and cash deposits, whose returns failed to match the inflation. While the inflation risk might be lower now, so are returns on gilts and deposits.
ANDREW BELL,
Head of Research,
Rensburg Sheppards
