Huge Opportunity from Moody’s Downgrade of U.K.

Most of the focus on Moody’s downgrade of U.K. debt to Aa1 from Aaa yesterday has been on the potential negative repercussions — and there are some. But it also creates an enormous opportunity in the chance to ease front-loaded austerity.

The downgrade should change the government’s calculus when putting together the budget, which it will publish on March 20. Until now, the Prime Minister David Cameron and Chancellor of the Exchequer George Osbourne have clung to their austerity plans in the 2012-2013 and 2013-2014 fiscal years, partly in an effort to stabilize the U.K.’s public debt burden and maintain the Aaa rating. Now that the top rating is no longer there to protect, the government might be more inclined to loosen its short-term fiscal targets.

This is what the U.K. needs if it is to return to robust economic growth any time soon, because there is little sign of a rescue from external demand. The same day that Moody’s downgraded the U.K., the European Commission released its forecasts for the euro area, indicating that the currency union will contract yet again this year. Around 40 percent of the U.K. exports go to the euro area, so the economy will need to rely on domestic demand for growth. This can only happen if the government stops its front-loaded austerity measures.

There is no question that this will be a big political blow for Cameron, Osborne and the Conservative Party, who largely staked their election prospects on implementing the fiscal measures required to ensure that the U.K. kept its triple-A rating. There may also be sell-offs in the bond markets as a result of the downgrade, although the news was mostly priced in long ago. Still, Cameron and Osborne respond as they should, this downgrade could be good news for the U.K. economy in the short-term.

This piece was originally posted on Bloomberg View.

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