Saturday, 19 January 2013

Credit and credibility: France and the UK

At the Treasury Committee in October, I came under sustained questioning as to my view that low long-term interest rates in the UK reflect economic weakness (domestic and global) and expectations that short-term interest rates set by the Bank of England will remain very low (again, reflecting economic weakness); and not, in any meaningful sense, the "credibility" of government fiscal policy or economic strategy more generally.  A much more detailed discussion is here

So, for example, Andrew Tyrie, the Chair, asked:
"You would agree, would you not, that we have picked up some enduring credibility, notwithstanding your initial remarks, as a consequence of the introduction of a fiscal plan a little over two years ago, and that this is reflected in the differential between long-run debt service costs in the UK and in other countries?
This is a QTWTAIN, as the IMF has shown. But when I pointed this out, Jesse Norman got rather puzzled that I wouldn't give the government any "credit", as he put it:
 "I am very struck by the fact that you are not prepared to give the Government any credit at all on a 300 basis point difference between UK policy now versus Italy, and two years ago. That seems extraordinary to me....You seem to be extraordinarily unwilling to give any credit or credibility". 
Giving evidence in a subsequent session, the Chancellor, perhaps not surprisingly, was much more prepared to give himself some credit: 
"I think the principal driver of why our rates are low compared to some other countries-and it is partly a relative game-is because of the credibility of the UK fiscal policy."
Well, let's apply the logic of Mr Tyrie, Mr Norman and the Chancellor, and try to give credit where it is due. Of course the UK fiscal consolidation plan of 2010 - Plan A - has now largely been abandoned, as I point out here (Q3).   But fortunately we have a more recent example. In another large European country, a government was recently elected promising a radical change of economic policy - fiscal and otherwise.  Since as the Chancellor says, credibility is a relative game, let's see what happened to long-term interest rates in France and the UK over the past year, and in particular since M. Hollande was elected in May 2012. 



Well, that's pretty clear isn't it? French yields fell sharply at the time of M. Holland's election and the subsequent few months, and have been stable since. Gilt yields fell in the first half of the year, but have risen somewhat since.  So spreads between the two have fallen quite sharply - from more than 50 basis points before the election to close to zero now.  

Obviously, this convergence must reflect the fact that, subsequent to M. Hollande's election, French fiscal policy (and economic policy more generally) is now much more credible (and just as  "credible" than that of the UK).  Mr Tyrie, Mr Norman and the Chancellor must surely agree - as Mr Norman would put it, it would be simply "extraordinary" not to.

Of course this would be utter nonsense. French yields have decreased relative to gilt yields because French economic prospects have got worse since M. Hollande's election; meanwhile, the UK's, while not significantly better than then, haven't worsened further (see here).  Indeed the recent uptick in gilt yields probably reflects some (cautious) optimism among market participants; good news, as I pointed out some time ago.  This is entirely consistent with the theory and evidence set out in the first paragraph above and in my other articles.  [Note that this may not last - as has frequently been pointed out, if things get even worse, France, which does not borrow in its own currency and does not have its own central bank, is potentially vulnerable to a bond market run, unlike the UK].  

There is a separate debate about exactly why things have got worse in France and the extent to which M. Hollande is to blame. Personally, while much of it is due to events which were already in train prior to his election (in particular self-defeating austerity in Europe), I would also argue that he has made a number of serious economic mistakes; what France needed was a government that would slow or reverse austerity (in France and Europe) while accelerating structural reform (of labour markets and public services).  Sadly, very much as in Spain, this is not what is happening; if anything the reverse is true.  

But you don't have to agree with this particular view of France's economic conjuncture to see that anybody who really believes in the "credibility" argument must think France is doing something very right, at least relative to the UK.  

2 comments:

  1. Mr Portes
    You seem highly concerned with credibility.
    Is it credible to compare, or even to imagine, that bond market participants might wish to distinguish between a party that has been in power nearly 3 years and one that has recently come to power? Have you even looked at French vs UK debt auction schedules?
    You are effectively saying that it is impossible for the UK govt to have gained some credibility yet simultaneously for the French situation to have worsened, the basis of you're claim or argument being that because the French could NOT have earned confidence (presumaby it is too soon since their election) then the reason for there rates moving down MUST be the same as the reason that UK rates have moved down. Why should it be the same? And would you reverse your position if French rates move higher?

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    1. Hi Robert
      In their report from July 2012 the IMF sheds some light on the subject of credibility, which concurs with Portes' argument above - namely that bond rates have little to do with 'confidence' derived from credible fiscal management (deficit reduction) for advanced economies with monetary and central bank independence. Rather, they say the low rates are to do with current and future expected weak growth prospects.
      See page 38-39, especially paragraph 43. (Paragraphs 43-48 are also highly relevant) of the pdf link below:
      http://www.imf.org/external/pubs/ft/scr/2012/cr12190.pdf

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