(Yes, the titular wordplay was intentional.)
(Yes, the titular wordplay was intentional.)
For those not familiar, supply-side economics assumes supply creates demand. People don’t know they want a certain good unless it exists, so innovation and creation—not existing demand—must drive production. For an example, consider automobile inventor Henry Ford’s famous quote: “If I had asked people what they wanted, they would have said faster horses.”
Bowie hasn’t released a new album since 2002’s Heathen, he hasn’t toured since suffering a heart attack after a gig in 2004, and his last major film role was in 2006’s The Prestige. London Olympic organizers offered him a spot in the closing ceremony, but he politely refused. Though not exactly a recluse—he’s made a handful of public appearances and is photographed strolling in New York now and again—by all accounts he’d settled into retirement and quiet family life. His performing and recording days, it seemed, were through—and though we fans never lost hope for a new album, we weren’t exactly signing petitions or pleading our case in record company focus groups.
But on January 8, something miraculous happened: A new Bowie single, “Where Are We Now?” appeared on iTunes out of the blue. With no marketing campaign other than a press release, a tweet on Bowie’s Twitter feed and a banner on iTunes, news spread across the Internet like wildfire, and within a day the song topped the UK iTunes chart. The simple existence of a new song drove a massive wave of demand—demand that really didn’t exist the day before.
And that, in a nutshell, is why the best economic policies are those that make it easiest and cheapest for people to innovate, create and sell their goods—all the fiscal and monetary stimulus in the world won’t do much to stimulate consumption without exciting new products for us to buy.
(And speaking of exciting new products, a new Bowie album, The Next Day, lands in early March.)
You may not think press regulation has much bearing on markets, but the deepening fractures within the coalition very well could.
UK Chief Secretary to the Treasury Danny Alexander caused a bit of a stir earlier this week when he said keeping the UK’s top credit rating should not be the “be-all and end-all” of the government’s priorities—apparently contradicting Chancellor George Osborne’s declaration that Britain’s AAA rating means the “world has confidence” in the coalition’s deficit reduction efforts.
Alexander’s reasoning was that the coalition’s efforts would be better spent on supporting economic growth—likely through higher infrastructure and other public spending—than reducing the deficit. How much the UK needs fiscal stimulus right now is debatable—certainly it has its time and place, though I believe private sector-oriented programs like UK Guarantees and Funding for Lending seem a more sensible means of boosting growth at the moment. But Alexander’s assessment of the credit rating’s importance hits the mark.
One year ago, the US was downgraded by ratings agency Standard and Poor’s, and at the time most observers were sure financial chaos would ensue. The US’s interest rates would rise, according to the popular narrative, the Treasury would have an increasingly difficult time issuing new debt, and eventually the US would default on its obligations. Well, none of this has happened. In fact, US Treasury yields have fallen since the downgrade and are at multigenerational lows. This is largely because investors the world over understand the US has very deep, liquid capital markets and debt backed by the full faith and credit of the US government is relatively low risk.
I suspect the same would ultimately prove true in the UK if it were ever downgraded. Britain, too, has deep and liquid capital markets, and the Treasury’s ability to reduce bank lending rates simply by putting its strong balance sheet behind over £120 billion in new loans speaks to the market’s faith in its ability to repay its debts. Markets tend to see this much more accurately than ratings agencies, which tend to base their assessments on factors that are already widely known or shouldn’t really enter into consideration at all (for example, S&P’s reason for downgrading the US’s rating was that Congress took too long to increase the Treasury’s borrowing limit, which is a mere formality).
In short, provided the Treasury continues its sensible approach to managing the country’s finances, markets likely shouldn’t much care what the UK’s credit rating is.
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Perhaps this isn’t a perfect analogy, but the latest spat between France and Britain brings to mind this classic scene from Monty Python and the Holy Grail:
Frenchman: You don’t frighten us, English pig-dogs! Go and boil your bottoms, sons of a silly person! I blow my nose at you, so-called Ah-thoor Keeng, you and all your silly English Knnnnnniggits!
Sir Galahad: What a strange person.
King Arthur: Now, look here, my good man—
Frenchman: I don’t want to talk to you no more, you empty-headed animal food trough wiper! I fart in your general direction! Your mother was a hamster and your father smelt of elderberries!
Sir Galahad: Is there someone else up there we can talk to?
Frenchman: No, now go away or I shall taunt you a second time!
In case you haven’t been following too closely, here’s what’s happening. The US-based credit ratings agencies (Fitch, Moody’s, and Standard & Poor’s) have put France ’s credit rating on a negative watch, suggesting a downgrade may be forthcoming. France ’s government introduced a fresh €65 billion austerity package in early November, but thus far it doesn’t seem to have quieted rumors of a pending downgrade. Now, France seems to be trying to distract the ratings agencies a bit.
It started last Thursday, when Bank of France governor Christian Noyer told a French newspaper (see The Independent for a partial translation) a downgrade “doesn’t strike me as justified based on economic fundamentals. Otherwise, they should start by downgrading the UK , which has a bigger deficit, as much debt, more inflation, weaker growth and where bank lending is collapsing.” French Prime Minister François Fillon chimed in, “Our British friends have a higher deficit and debt, but it seems the ratings agencies have not yet noticed.”
David Cameron responded diplomatically, reminding folks his cabinet has spent 18 months tackling deficit reduction. He also pointed out that low yields on British sovereign debt demonstrate the market’s faith in Britain ’s ability to service its debt. (If risk of default were higher, one would expect yields to rise accordingly. British 10-year gilts yielded a very low 2.04% as of market close on 16 December.*)
Undeterred, France’s new finance minister, François Baroin, shot back: “The economic situation in the United Kingdom is very worrying. One would rather be French than British at the moment.” A private conversation between Monsieur Fillon and UK Deputy Prime Minister Nick Clegg followed, moving the debate behind the scenes.
Heated politics aside, the real story here is the strange methodology of ratings agencies. As Mr. Noyer pointed out, ratings agencies seldom base their assessments on economic fundamentals. Fisher Investments’ editorial staff has written at length about the rather odd methodologies behind ratings agencies’ assessments, and in short, we don’t see why anyone lends them much credence.
So, with that in mind, what might the ratings agencies be looking at in this case?
Cameron’s statement perhaps offers a hint. The UK’s deficit reduction plans seem largely on track thus far, and the deficit narrowed more than forecast (thanks to higher revenues) in November. France has announced credible deficit reduction measures, but they’re not quite as far in the process. The UK also has the benefit of not using the euro—France, by contrast, is saddled with the perceived risk associated with being in the eurozone. France’s banks also have more exposure to peripheral Europe’s sovereign debt, raising the specter of state-funded bank recapitalizations (which could hinder France’s austerity efforts).
And then, there’s future growth prospects. Both countries have witnessed slow GDP growth this year. But looking longer term, Britain’s economy has some competitive advantages. The Heritage Foundation ranks Britain 16th in the world in its 2011 Index of Economic Freedom. Business regulations are largely transparent, efficient and streamlined, according to the Heritage Foundation’s report, and labor markets are flexible. Britain also plays a major role in the global economy—London is one of the top-three global financial centers (with New York and Hong Kong), and the UK’s international trade totaled £906.5 billion in 2010.**
France’s economy, on the other hand, is somewhat less liberalized, though Sarkozy has introduced some measures to change this during his presidency. Several utilities remain state-owned, its agriculture is quite subsidized (largely by EU neighbors) and its labor market is heavily regulated. The Heritage Foundation ranks it 64th in the world in its 2011 Index of Economic Freedom, citing the knock-on effects of a “rigid labor code.” Certainly, as the eurozone’s second-largest economy, France is a major player and has plenty of economic prowess—its international trade in 2010 totaled £700 billion.*** But there are opportunities for further structural improvements.
So why might this factor into the ratings agencies’ assessments? Higher economic growth can make it easier for nations to service their debt over the years—higher GDP can lead to increased state revenues, which can make interest payments less expensive relative to revenues. Lower growth can make that a bit more difficult. Hence why Moody’s warned this week that slower economic growth in 2012 could impede Britain’s deficit reduction progress, though it affirmed its top credit rating is stable for now.
Again though, the takeaway here isn’t that one nation’s any stronger than the other or one side any more right, but that ratings agencies’ assessments should be taken with a healthy dose of cynicism. Both nations seem plenty capable of servicing their debt.
**Source: Office for National Statistics
***Source: National Institute of Statistics and Economic Studies
Hamish McRae at the Independent has a sound take on the recent slew of seemingly negative news about Britain ’s economy: “The best way to make sense of this constant barrage of information, most of it negative, is to keep asking what is actually new and what is a rehash of stuff we already know.”
This is always a sensible approach. By the time information is widely known, markets have typically already reacted to it. Even when old information is spun in different ways, it usually doesn’t have much power to move equities meaningfully, in either direction. Markets have already moved past it and are pricing in new information and the probabilities of different events happening. It’s a lot like driving a car: Looking only in the rear view mirror doesn’t tell you what’s on the road ahead of you.
To borrow one of Mr. McRae’s examples, consider last week’s news that Moody’s downgraded the credit ratings of 12 British banks. The downgrade, of course, was a new event. However, it was long expected and—importantly—based on things we already knew about these institutions. If smaller banks come under stress, the government will probably let them fail, while larger banks, with deeper ties to the British and global financial systems, will more likely receive some government support in order to lower the risk of their troubles spilling over. The government has been heading in this direction for a while, as demonstrated by the Independent Commission on Banking’s recent proposals for financial sector reforms. Moody’s simply took this old news and gave it new clothes, in the form of a rating downgrade. And to perhaps confirm the downgrades don’t really change anything, Moody’s vouched for the UK banking system’s overall health: “The downgrades do not reflect a deterioration in the financial strength of the banking system or that of the government.”
Another recently repackaged item is the UK ’s second quarter 2011 economic growth. Last week, the Office for National Statistics announced the economy grew only 0.1% from April through June, less than originally estimated. Though flattish growth isn’t great news, it’s important to put it in context: the number is now more than three months old. As highlighted in our last post, some key economic indicators suggest growth picked up in the third quarter. Mr. McRae adds, “our service industries are still expecting growth and, what is more, are still profitable.” Looking at only the second quarter’s reading doesn’t really tell us what’s happened in the three-plus months since—and, much less, what will happen from here.
It wouldn’t be surprising for negative economic news to continue. But taking a minute to distinguish well-known stories from those with new information can give us all a healthier perspective, and a better sense of how the economy is truly progressing.
*The Smiths, 1987
Last Thursday, Bank of England (BOE) Governor Mervyn King received widespread attention for suggesting Britain’s present economic situation “is the most serious financial crisis we’ve seen at least since the 1930s, if not ever.” This was his rationale for implementing a new round of quantitative easing: The BOE will purchase £75 billion worth of gilts over the next four months, which should in theory then be lent from banks to individuals and corporations, providing a tailwind to economic growth.
Setting aside questions of the plan’s advisability, is Britain ’s economy truly in as bad of shape as Mr. King suggested? Is today as bad as, if not worse than, the Great Depression?
There’s no doubt the British economy faces challenges, and growth has slowed lately. However, true depression requires a massively shrinking economy, as occurred during the 1930s—but which hasn’t occurred so far in 2011. In fact, the UK ’s nominal GDP is at an all-time high, having recovered from the 2008-2009 recession. Much has been made of recent news the economy grew only 0.1% in the second quarter, but it’s rather normal for economic growth rates to fluctuate in the short-term. Growth often slows temporarily a couple years into an expansion without turning negative.
Following are some other positive highlights from the Office for National Statistics’ Second Quarter 2011 Statistical Bulletin:
Other recent reports also suggest the economy is healthier than given credit for:
Based on these facts, it seems premature to say the UK is in either a depression or recession. More likely, it’s experiencing the volatility typical during a growth cycle.
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