UK debt and default

There’s been a bit of discussion about the possibility that the UK government’s debt might be downgraded by the ratings agencies.

In response to those suggestions Jonathan Portes claimed that “…unlike countries in the Eurozone, there is no possibility of the UK defaulting, so our fiscal policy is not constrained by markets in the same way; and we should ignore the credit rating agencies, because they’re irrelevant.” He cites the head of the OBR, Robert Chote, as support for that view. Now I don’t deny that there is little chance of the UK defaulting, but I think Portes is only telling half the story.

There are two points here: the risk of default, and the importance of the rating agencies. The point about the rating agencies is that they don’t have inside information so they can’t move the market much. Essentially, all the information that they use to decide on a downgrade will already have been priced in to the cost of debt by the time they make their decision. That is the reason most people aren’t too worried about a downgrade for the UK, although it has some value as an indicator of risk if one isn’t familiar with the movements in the markets.

The second point is that a country with a sovereign currency can always inflate away its debts. By issuing currency to pay the debts it ensures that it won’t need to default, but it also reduces the real value of the debt. Dealing with extreme debt levels by inflating it away is really a partial default on the debt: the lender gets back far less than they expected when it was issued. Obviously borrowers aren’t mugs and recognise the risk of a partial default when they purchase the debt. If they think it likely then they will require a far higher yield to induce them to lend. Even if you can avoid defaulting, the risk of an inflationary partial default is still priced in to the cost of your debt.

There may be no imminent risk of default, but the failure of markets to react to a downgrade and the existence of a sovereign currency do not mean that the UK can ignore debt markets. Continually rising debt levels will eventually have consequences for its cost of borrowing whoever controls the currency.

3 replies
  1. Matt Nolan
    Matt Nolan says:

    Yar, one of the advantages of an explicit target for the price level/growth (this includes NGDP) is that it commits to a path of not defaulting on the real value of debt – and so reduces the risk premium faced my government ex ante.

    I can understand where Portes and Chote are coming from, as in the most extreme case we may be willing to break this commitment (where the expected future benefit of credible commitment is lower than the reduction in cost to govenment – so our time inconsistency issue is essentially irrelevant). However, it is good for you to raise the other side of the coin.

    • jamesz
      jamesz says:

      Wasn’t that last point the one being promoted by Wren-Lewis a few weeks back?

      Also, I don’t disagree with them about the likelihood of default, but I can’t see how anyone could think that there will be no market reaction to those risks. I think they’re just simplifying and discarding low probabiliy events for the sake of exposition, which is fair enough when you’re talking to a general audience.

      • Matt Nolan
        Matt Nolan says:

        I hope he did make the point, as it’s more likely to be right in that case 🙂

        Indeed. I am glad to see you bring up the flipside, because non-economists often forget we are talking about a very specific case due to the ZLB – rather than a commitment you can just break for kicks all the time!

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