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Julian D. A. Wiseman
Abstract: despite Moody’s downgrade, the Bank of England can’t default in sterling.
Publication history: only at www.jdawiseman.com/papers/finmkts/20130224_moodys_downgrades_bank_england.html. Usual disclaimer and copyright terms apply.
Contents: What is a rating?; Legal tender; Institutional quality; The problem; Afterword.
On 22 February 2013 Moody’s downgraded the United Kingdom and the Bank of England to Aa1 from Aaa.
What does this mean? What is a rating? Turn to page 8 of Moody’s: Rating Symbols & Definition, dated June 2009.
Moody’s long-term obligation ratings are opinions of the relative credit risk of fixed-income obligations with an original maturity of one year or more. They address the possibility that a financial obligation will not be honored as promised. Such ratings use Moody’s Global Scale and reflect both the likelihood of default and any financial loss suffered in the event of default.
All very fair — a rating is an opinion about a relative probability of default.
Before going further, observe what this is not. This is not a probability that the numéraire of the debt will devalue relative to other currencies. Indeed, in mid 2008 the pound was above $2; by early 2009 it had fallen to below $1.40, yet this was not default. Gilt coupons were paid in the promised number of pounds, which had become fewer dollars. Yet Moody’s, far from deeming the UK to be in any form of selective default, instead continued to rate the UK, and the BoE, at triple-A.
Likewise, inflation (devaluation against bread or beer rather than against USD) is not default. Since 1978 the RPI-based purchasing power of the pound has fallen almost five-fold; and for most of 2011 year-on-year RPI inflation was over 5%. Yet this was not deemed default: all the rating agencies had the UK and the BoE at triple-A.
So, importantly, default means actual default. I owe you £1; I fail to pay that £1 punctually; I have defaulted. Whether that £1 changes in value is not relevant to the presence or absence of default, and hence not directly relevant to a rating.
Whilst at SocGen I wrote that UK £ default is not only unlikely, it is de facto impossible (9th November 2011). Much of that argument was about the legislation and Parliamentary procedure by which a government could compel the issuer of GBP, the Bank of England, to lend or give sterling to the government. (Summary: s.12 of the National Loans Act 1968 gives the Treasury much more power than is held by, for example, the US Treasury; and if that fails s.19 of the BoE Act 1998 gives the gov’t all the power it needs to extract money from the BoE.)
But Moody’s has gone further than lowering the UK: in a one-sentence aside, it has lowered the rating of the Bank of England.
In a related rating action, Moody's has today also downgraded the ratings of the Bank of England to Aa1 from Aaa.
That greatly simplifies the argument.
If I owe you £100, how can I settle that debt? There are two forms of legal tender.
First, bank notes. Residents of the UK are familiar with folding portraits of Her Majesty The Queen. But there used to be bigger banknotes, much bigger. There used to be ‘Giants’, each being a £1,000,000 note. They were needed, only inside the Bank of England, never leaving the Bank of England, for an obscure reason relating to the Bank Charter Act 1844, a reason that was made redundant by s.217(2)(c) of the Banking Act 2009. In 2003 I held a £1,000,000 banknote: A5, blank one side, the one printed side being black-and-white. It might have been laser printed! This was legal tender, for a million pounds. Cool: off to the pub—“got change for this love?” Some years later the BoE printed some ‘Titans’, bank notes with a face value of £100,000,000, but I never touched one.
So the BoE could easily make legal tender with which to pay its debts. If the BoE owes me a trillion pounds, all it would take is a few hours of work to design and laser print some new pictures, and a wave of the Governor’s magic this-is-legal-tender wand, and then I’m paid. Of course, if the BoE were to start handing out easily forged £1×1012 notes, the value of the pound would fall, internally and externally. But that would not be default.
The second form of legal tender is money on account at the Bank of England. Money on account at the BoE is a liability of the BoE’s. The BoE, by acknowledging that debt, and allowing it to be in the form of a bank balance, would have paid. No need even for laser printing.
So there is no form of economic problem or weakness that could push the BoE into default.
This doesn’t quite make default impossible. The Nazis, after Kristallnacht, wanted to ban German insurers from paying Jewish claims. The insurers argued against this, saying it would damage their creditworthiness in international markets. So instead the government imposed a 100% tax on such claims. But this ‘default’ was caused by a breakdown of both the quality of institutions and access to justice. This is not applicable to this case: Moody’s argument for a downgrade is all about economics, whilst praising the “robust institutional structure”.
The downgrade of the Bank of England has been caused by a methodological error of Moody’s. Moody’s methodology takes no account of the degree and quality of the issuer’s control over the numéraire of the debt. Instead, sovereigns are treated as large railroads, with tax income, debts, and various other outgoings. Perhaps that might be fair for eurozone sovereigns, which have ceded their control over the currency. Perhaps that might be part-fair for the USA, which has unwisely split control over the numéraire between the Executive and the Legislative, who are sometimes keener on squabbling than on the public interest. But for the Bank of England or the Federal Reserve or the European Central Bank, it is a nonsense.
|— Julian D. A. Wiseman|
London, 24rd February 2013
Monday 25th February 2013: this essay was the subject of an FT Alphaville article at http://ftalphaville.ft.com/2013/02/25/1397752/this-downgrade-is-nonsense/.
The question then is: what exactly does a rating mean for a sovereign which borrows in its own currency? Right now, it seems little bar political pain.
Moody’s should not be pleased that its rating is thought to have little meaning.
July 2016: published at jdawiseman.com an update of UK £ default is not only unlikely, it is de facto impossible.
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