Re: Funding and the Patriotism Test

Dear Gillian,

Many thanks for the wonderful insight. You are one of the few journalist who is honest and speak with clarity.

My only issue is you have started the article with credit rating agencies prospective behaviour. I say that by doing this you are giving credibility to the rating agencies. The rating agencies job was to act like a guide to the real investors (not investment banking speculators). But they not just failed in their job but have deliberately misled them.

I would have thought that till the rating agencies are reformed (by removing the conflict of interest - the rating agencies are paid by the companies whose products they rate) the rating agencies should be totally ignored or ostracized. It doesn't matter what they think.

I hope you do not disagree.

Regards,

Pradeep Kabra

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Funding and the patriotism test
By Gillian Tett
Published: January 7 2010 21:03 | Last updated: January 7 2010 21:03
In recent months, some of the brightest minds at Moody’s rating agency have been mulling a fascinating question: should they introduce a formal rating of “social cohesion” into sovereign debt indices, when they judge whether a government is likely to default on its debt – or not?

So far, neither Moody’s nor any other agency has actually done this, after all it is pretty hard to feed a specific “cohesion” number into any model.

But the discussion points to a fundamental issue that will hang over bond markets this decade.

In the past few years, when markets have tried to judge the risk attached to western government bonds, they have typically done so looking at hard macro-economic data, such as projected gross domestic product. Such data, of course, continue to be critically important, given the size of the western fiscal hole.

What is becoming clear is that hard numbers do not tell the entire tale. What will be equally crucial in the coming years is not the sheer scale of debt, but whether governments can implement a rational and effective way of cutting it – and potentially allocating pain – without unleashing (at best) political instability, or (at worst) full blown revolution.

Does a country, in other words, have enough political and social “cohesion” to take truly tough choices, or even rewrite the social contract? What makes that issue doubly fascinating is that the answer may well vary in different parts of the bond market, in the years to come.

At one end of the spectrum there is a country like Japan. A decade ago, I worked in Tokyo as a reporter and was often struck by the skill with which Japanese institutions shared out pain, without triggering social unrest. Whenever companies ran out of cash, for example, their instinct was usually to spread the impact (by, say, cutting everyone’s salary) rather than pick winners and losers (sack a few staff.)

Some observers blame that on Japan’s obsession with maintaining cultural harmony; many Japanese point to the fact that they live in an island with constrained resources. Either way, this emphasis on sharing pain in an equitable manner is likely to shape how the government tries to impose public spending cuts in future years.

It may impact bond market behaviour. One striking feature of the Japanese government bond markets in recent years is that domestic investors (who own 95 per cent of outstanding JGB stock) have continued to buy bonds, even amid ratings downgrades in the JGB market, with an extraordinary sense of quasi-patriotism. That is bad in some respects, since it removes pressure for change; but it may also make it less likely that Japan will rip itself apart.

However, in the US, the government has less experience of dividing up a shrinking pool of resources. Instead, in a land built by pioneers, Americans prefer to spend time thinking about how to make the pie bigger – or to find fresh frontiers – than about making shared sacrifices.

Thus it remains an open question whether Washington will be able to slash without real political or social upheaval. Signs of tension are already there: Bill Gross of Pimco, for example, this week warned that “our [American] government does not work any more; or perhaps more accurately, when it does it works for special interests and not for the American people”.

The situation of the UK is perhaps even more fascinating, given that it faces an election this year – and is at more immediate risk of a ratings downgrade. The British government has the “advantage” (if one can call it that) that voters are long used to the concept of national decline, and relatively recent memories of fiscal belt-tightening.

But social cohesion and patriotism in the UK are fragmenting, and investors in gilts are apt to be far less patriotic than in Japan (not least because only 50 per cent of the gilt market is in domestic hands).

So will UK politicians be able to implement radical reforms with a spirit of shared sacrifice? Or will they do what Icelandic voters have done this week – and derail a government plan? And how will gilt investors react, as a country such as the UK starts fighting this out, or loses its triple A credit rating?

Right now, the answer is simply unknown. But the key point is this: if the past two years were a crucial test for global financial markets, the next two will be an equally critical test for the system of western government.

Stand by to see plenty more volatility and uncertainty in the government bond markets. The really big risk factors, be it in Iceland or the UK, the US or Ukraine, can no longer be easily factored into a spreadsheet.

gillian.tett@ft.com