"Inflation in the UK is now more than double that of France, but only one country has had its credit rating downgraded. This column argues that government credit ratings should be aided by a second rating measuring the potential loss of real value, whether by inflation or default.
The authorities in Britain are proud of the fact that over the last three centuries there has been no default on British government debt, despite debt-to-GDP ratios climbing to high levels (near or over 200%) after each of the three main wars. But that did not mean that holders of such debt were necessarily paid back in full in real terms. At the start of 1946 the nominal value of 3½% Consols was £104.7; at the start of 1986 its nominal value was £34.75, and in the meantime the price level had risen from 27 to 385.9 (1974=100), about 13 times. So the real value in 1986 was about 1/40 or 2½% of its 1946 value, a real haircut of some 97½%, though this ignores interim coupon payments. Inflation, especially anticipated inflation, can destroy real value as quickly and surely as default.
In the last three years, for example:
By this single criterion of the probability of default, it would seem that any country with command over its own printing press should be AAA, since it can always inflate its (nominal) debt away. “Not so,” claims S&P as it downgrades the rating of the US, since one must consider willingness as well as the ability to pay. But that position has some absurd logical implications..."
at http://www.voxeu.org/index.php?q=node/7591
The authorities in Britain are proud of the fact that over the last three centuries there has been no default on British government debt, despite debt-to-GDP ratios climbing to high levels (near or over 200%) after each of the three main wars. But that did not mean that holders of such debt were necessarily paid back in full in real terms. At the start of 1946 the nominal value of 3½% Consols was £104.7; at the start of 1986 its nominal value was £34.75, and in the meantime the price level had risen from 27 to 385.9 (1974=100), about 13 times. So the real value in 1986 was about 1/40 or 2½% of its 1946 value, a real haircut of some 97½%, though this ignores interim coupon payments. Inflation, especially anticipated inflation, can destroy real value as quickly and surely as default.
Explicit default versus real default by inflation
Credit ratings do exactly what is claimed on the tin – they measure the risk of default. Indeed credit-rating agencies have done conspicuously well in the recent sovereign debt crisis, downgrading Greece before the market caught on and speaking truth to power. But such ratings do not, and have never claimed to, measure the probable loss of real value from holding nominal government bonds owing to inflation.In the last three years, for example:
- Inflation in France has averaged 1¼% compared with 3⅓% in the UK.
- Expectations of future inflation, as measured by the margin between indexed and nominal bonds are 1.6% in France and 2.5% in the UK.
By this single criterion of the probability of default, it would seem that any country with command over its own printing press should be AAA, since it can always inflate its (nominal) debt away. “Not so,” claims S&P as it downgrades the rating of the US, since one must consider willingness as well as the ability to pay. But that position has some absurd logical implications..."
at http://www.voxeu.org/index.php?q=node/7591
