Now the dust has settled on 'Double-Downgrade Day', it's worth looking at what it all means.

It's tempting to accept the government's dismissals and deflections of the Double-Downgrade as somehow an irrelevant or accidental mistake that means little in the great scheme of things and can't really be blamed on the government.

After all, the Government successfully sold a record $1 billion worth of bonds just yesterday at record low interest rates. It sure doesn't sound like the bond vigilantes are about to gang up on New Zealand to force us into line. Bond investors are practically begging to buy our paper. It may be because we're about as far away from Europe as anyone can get, but it's hard to pull the wool over the eyes of these Masters of the Universe.

Surely there can't be that much of a problem?

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Maybe we can just ignore the ratings agencies. After all, they rated all that toxic sub-prime dreck in America as AAA and Standard and Poor's credit rating downgrade for America was greeted by a mass rush into (not out of) US Treasury bonds. The US 10 year Treasury bond yield has fallen to 1.7 per cent from 2.5 per cent since the downgrade on August 5.

The New Zealand dollar fell about 1 USc after the Fitch downgrade on Friday morning and is only down about a further 20 basis points as I write this late on Friday evening after the Standard and Poor's downgrade. That's not a major fall given the recent history of much bigger falls after slumps on overseas stock markets.

New Zealand interest rates didn't rise that much, only edging around 5-10 basis points higher on the day. The New Zealand stock market even rose.


Finance Minister Bill English seemed relatively relaxed when saying the downgrades were more about the concerns of foreign investors about high debt generally, rather than a specific concern about New Zealand. He said the goal posts had been shifted on global debt. The implication was it wasn't New Zealand's or the government's fault.

English also said the agencies comments about a rising current account deficit were not concerning because he thought they were wrong about households getting back on the foreign debt-fuelled consumption wagon.

He was also more confident about New Zealand's export returns because our links to Asia would insulate us from any recessions in America and Europe.

'Not embarrassed'

John Key, fresh from hosting a show on Radio Live, told reporters the ratings agencies seemed most concerned about New Zealand's private debt, which weren't new and had been built up before he came into office.

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He said he was not at all embarrassed by the verdicts from Fitch and Standard and Poor's and believed New Zealand's economy and public accounts remained stronger than many others, and stronger than when he came to office.

Before we look at the flaws in the government's deflections, let's look at what the credit ratings agencies actually said.

Fitch said it was concerned about New Zealand high net external debt and its consistently high current account deficit. It said New Zealand hadn't transformed enough into a producing/saving/investing/exporting economy yet to bring that current account deficit down.

Standard and Poor's said it was worried New Zealand's budget had been weakened by the earthquake and the fiscal stimulus used to sustain growth. It said New Zealand's sound monetary policy and stable political situation were good things, but:

"These strengths are moderated by New Zealand's very high external imbalances, which are accompanied by high household and agriculture sector debt, dependence on commodity income, and emerging fiscal pressures associated with its aging population," said S&P's Kyran Curry.

So let's break this down

Firstly, both Fitch and Standard and Poor's are worried about New Zealand's collective foreign debt, including both private (which means bank debt) and public debt. Their unspoken assumption is that these two types of debt could become the same thing over time, if the government ever had to bail out the banks. The ratings agencies have begun lumping the two types of foreign debt together in the wake of the Irish crisis where the government guaranteed the banks debts as soon as they got into trouble.

The ratings agencies have worked out in recent years that private debt pretty quickly becomes public debt whenever banking systems hit trouble because politicians can't help themselves from bailing out banks.

This is the first sign that the ratings agencies are not confident in the government's avowed policy of not bailing out the banks.

See more about that policy here in Alex Tarrant's article on English touting New Zealand's unique Open Bank Resolution or 'living wills' policy which would allow a bank to fail in an orderly fashion.

The ratings agencies have recent form to consider here. The South Canterbury Finance bailout was actually a bigger bailout for New Zealand's economy than the collapse of Lehman Bros was for the American economy. And just last week the government confirmed a bailout of AMI.

Secondly, both think the government has not done enough yet to transform the economy from being a consuming/borrowing/importing economy into a saving/investing/producing/exporting economy. This has been the government's big theme since the election. Its big 'tax switch' package and its tweaks to rules on rental property were at the centre of this 'transformation' policy.

The trouble is it hasn't worked yet and doesn't seem to be working for at least a couple of years to come.

The ugly detail

The ugliest detail in the May 2011 budget was the Treasury's forecast the current account deficit would rise from 4.1 per cent in 2011/12 to 6.9 per cent in 2014/15. That's not a transformation. That's a deterioration. Bill English's comment that he didn't think New Zealand households would go on a spending spree and that New Zealand's current account deficit wasn't as bad as painted by the ratings agencies was contradicted by his own Treasury in the budget.

The high New Zealand dollar this year has been a huge disincentive to exporting anything other than highly priced commodities. The same old stuff is happening in the housing market. Central Auckland property is abuzz again with 95 per cent home loans and houses sold before auction.. Household lending is up more than $6 billion in the last two years, while farm lending is flat and business lending is actually down $5 billion.

See the RBNZ figures here. A real transformation would have seen a reversal of those figures.

Essentially, the New Zealand government has been running a structural budget deficit of around 3-4 per cent of GDP since around 2005. This was created firstly by Labour, which cut taxes for middle income earners and delivered the middle class welfare of Working For Families and Interest Free Student Loans. National kept those policies in place and expanded the tax cuts to middle and upper income earners, slightly loosening fiscal policy as it went.

Of course the earthquakes and the recession are responsible for a good chunk of the near $20 billion budget deficit this year, but a core portion of it is that structural deficit built up over the last 6 years and not removed by Labour.

One of the painful ironies of these Middle Class Welfare policies is that much of that money is being borrowed offshore and then recycled back into middle New Zealand is being spent on the usual stuff. Holidays, flat screen televisions, World Cup Parties, imported cars and, of course, more property.

It's no coincidence that the biggest rises in property prices have been in the wealthiest parts of Auckland where some of those tax cuts have been leveraged up to buy more expensive homes. The value of home loan approvals was up 28.8 per cent in the 12 weeks to September 23 from a year earlier, largely because the average loan size (rather than the number of loans) is up sharply. That suggests a good chunk of those tax cuts are being used fund upgrades by home owners into more expensive areas with a good extra lashing of debt. See the Reserve Bank figures here.

Not much has changed

This, for me, is the chilling realisation from today's double downgrade verdicts.

Not much has changed.

English and Key also accidentally acknowledge this in their slightly mystified comments wondering why Standard and Poor's and Fitch have downgraded New Zealand now. Why the downgrade when nothing new has happened, they asked.

Here's Key's comments:

"They are still expressing concerns about our private sector debt, and those levels are high. The good news is we are starting to get on top as a country of that private sector debt. The third factor that they're worried about is that so much of that private sector debt is owed to foreigners. That position's not new. That private sector debt was built up over the period of 2003 to 2008."

That's the real problem. Nothing or not much new has happened to solve those problems built up from 2003 to 2008. In fact, you could argue the giant tax switch and the governments continued heavy borrowing has made it worse, by pushing up the currency.

The government hasn't really addressed the problem of all the tax and lending incentives to invest in property. It has done nothing to improve the incentives to export and the disincentives to import. It could have done so much to improve national savings by removing the middle class welfare and simply reducing the government's own borrowing. Even the Savings Working Group said the fastest way to improve national savings and reduce the current account deficit was to cut the budget deficit and government borrowing.

But so far John Key has chosen not to spend any of his now-enormous political capital he has built up with all that easy charm and near ominpresence in the media. He is determined to win a second term and stay on as Prime Minister, an ambition he has apparently held since the age of 10. He seems to be enjoying the adulation as he opens World Cups, meets world leaders, hosts radio shows and attends royal weddings. He really has come up in the world.

But has New Zealand come up in the world since he came up in the world? Today the ratings agencies judged the nation's credit had gone down in the world.

'You haven't done enough, John'

Today some cold hard facts splashed in his face. They are facts he should understand all too well as a former foreign exchange trader.

These agencies are telling him he has not done enough to turn around the New Zealand ship. The agencies and investors believed the promise he gave in his Wall St Journal interview in March 2009 that New Zealand "can't spend its way out of a crisis."

Ratings agencies don't accidentally or routinely downgrade sovereign credit ratings. This is New Zealand's first downgrade in 13 years. They matter. An ANZ study showed how previous downgrades preceded significant downward pressure on the currency and the economy.

No one should forget also that the government argued in the 2009 and 2011 budgets that its supposedly tough measures were designed to avoid a credit rating downgrade. This is clearly an 'epic fail' as the programmers might say.

The price we'll pay

It's possible we won't pay much of a price immediately.

The New Zealand dollar does seem to be falling more sharply in early London trade as I write (nearly down through 76 USc), but the fall is unlikely to push up petrol prices much, particularly if a global recession also pushes the oil price down. If it does fall a lot then imports will be more expensive.

The Reserve Bank has already warned that higher bank funding costs because of the global economic turmoil could drive interest rates higher here, even if the Official Cash Rate does not rise.

Bank economists also gave gentle warnings today that was a possibility. It may take a long time and the banks should be careful to use up the 'fat' built up in their higher net interest margins in recent months before they pull the trigger on those rate hikes independent of the OCR.

Bill English said in a May 2009 release titled "Borrowing costs would rise under Labour" that Treasury had estimated the cost of a credit rating downgrade at around 1.5 per cent added to the interest rates paid by mortgage borrowers and businesses.

We'll see whether that happens, but if it did it would be a significant cost.