At the root of Moody's decision to downgrade Britain's credit rating is a crucial economic reality: Britain has begun to trail its peers in Europe - even bailed-out euro zone economies - when it comes to bringing down its budget deficit and making it attractive for foreigners to buy its exports.
Prime Minister David Cameron and his increasingly jittery coalition government have made deficit and debt reduction a defining priority. In December, his powerful chancellor of the Exchequer, George Osborne, warned that an austerity program that had already resulted in the elimination of tens of thousands public-sector jobs would have to be extended for a year longer than planned, to 2018. But that same austerity program has contributed to long-term economic malaise.
On Friday Moody's became the first ratings agency to strip Britain of its prized triple-A investment grade, reducing the country to Aa1. In its report, Moody's said one of the core factors behind its decision was the very slow pace of the British recovery.
Mr. Osborne said afterward that Moody's decision was "disappointing news," but he promised not to let the downgrade deflect the government from its deficit-cutting strategy.
The challenge Mr. Cameron and Mr. Osborne face in turning around the economy and changing Britain's status as a fiscal and trade laggard was underscored by two statistics released Friday in a widely anticipated European Commission economic forecast for the European Union.
The first is that despite presiding over one of the longest and highest-profile European austerity campaigns, the British government will end this year with a primary deficit — the purest measure of how much more a government spends than it receives in taxes — of 4.3 percent of gross domestic product. That is by far the highest such figure in Europe and second only to debt-ridden Japan among the world's developed economies.
The second is that even though the pound has lost up to a third of its value against major currencies since the onset of the financial crisis, Britain this year will be the only developed economy in the world that will register a current account deficit that will be higher, at 3.1 percent of G.D.P., than it was in 2009.
The current account balance is the broadest measure of a country's ability to sell its goods abroad. The larger the deficit, the more a country must borrow. All things being equal, a less costly currency should make it more attractive for foreigners to purchase a country's goods or invest in its assets. Export powers like Germany and China run large current account surpluses.
Mr. Cameron has touted the benefits of having a flexible currency, free of the constraints of the euro — and Britain may even hold a referendum on its continued membership in the European Union. But even euro zone countries like Spain, Greece and Portugal, which three years ago had gaping account deficits that drove them to the brink of collapse, have made dramatic improvements in this regard. The European Commission even sees Spain moving to a current account surplus this year.
Britain's persistent and worsening trade gap illustrates a troubling inability to increase exports even though the government has made this a policy priority. In his first address to Parliament, the incoming governor of the Bank of England, Mark J. Carney, pointed out that since 2000, Britain's share of global exports had decreased about 50 percent — the steepest decline among the world's 20 biggest economies.
The NYT Reports:
One explanation for the disappointing British record in narrowing its deficit and becoming more competitive is a surprising decline in productivity since the start of the crisis.
Since their economies tanked, countries like Spain, Portugal and Ireland have become more competitive by laying off workers. That should set the stage for a more robust return to growth once the recession ends.
In Britain, however, the opposite has been true: Despite stagnant economic growth, the British unemployment rate has remained relatively low, at just under 8 percent. In other words, Britain needs more workers to produce the same product — which, in addition to keeping the economy from growing strongly, pushes up labor costs, making exports more expensive to foreign buyers.
"Productivity is at the root of all of Britain's problems," said Robert Wood, an economist at Berenberg Bank in London who recently came out with a detailed report on the topic.
Moody's highlighted the essence of the country's productivity problem on Friday, when it said that the expected British growth rate of 1 percent this year was far below the long-term trend of 2 percent to 2.5 percent economic growth. In its report Friday, the European Commission projected growth of 0.9 percent in 2013, after no growth in 2012 and 0.9 percent in 2011.
Economic stagnation has made it harder for the government to reduce the deficit because tax revenues are not increasing as much as had been projected. Mr. Osborne extended the austerity program in December because the government had missed one of its self-imposed deficit-reduction goals.
Britain's austerity has included both tax increases and budget cuts. But the government led by Mr. Cameron has been reluctant to follow the example of the governments of those ailing euro zone countries that have taken a sharp knife to public-sector salaries, pensions and other benefit payments.
The most recent public finance figures for January show that public spending continues to increase in Britain, driven largely by social benefits. Those payments have risen by 6 percent over the past 10 months, with much of that figure driven by pension payments in addition to unemployment benefits.
The Moody's downgrade and the continuing problems in the economy could prompt foreign investors — who have thus far been heavy buyers of British government bonds — to sell their holdings on the view that gilts no longer represent a haven in troubled Europe.
Such an outcome is not guaranteed, of course. The United States lost its triple-A rating in August 2011 and France lost its in November 2012. The reaction from the bond market has been a collective yawn.
But the downgrade of Britain comes as the pound continues to slide. The currency has fallen more than 2 percent against the euro and nearly 4 percent against the dollar in the past two weeks after Bank of England officials said they were inclined to print more money in order to finance another program of bond buying in an effort to prod the economy into growth.
(Read More: UK Suffers Blow, Pound Seen Under New Pressure)
As hedge funds and other major investors increase their bets against the pound, bond investors will have more incentive to sell their holdings, especially if more downgrades are in the offing.
"The situation is unsustainable," said John Mills, an economist and entrepreneur who has long insisted that Britain must aggressively devalue the pound in order to improve its trade position.
"Britain is uncompetitive in the world," Mr. Mills said. "Sooner or later the pound will crack and the markets will come tumbling down."