The need for debt-rating in prudent economic management is pretty obvious, but the pickle the Europeans are in is that the debt rating agencies have really become buck-passing agencies: weak states have delegated the prudential work they ought to have been doing themselves as representatives of the public interest in the financial system. They are now embarrassed by the gaping void in public institutions.
Ha-Joon Chang, in Comment-is-Free, explains that the Western states
have installed a financial regulatory structure that is highly dependent on the credit ratings agencies. So we measure the capital bases of financial institutions, which determine their abilities to lend, by weighting the assets they own by their respective credit ratings. We also demand that certain financial institutions (eg pension funds, insurance companies) cannot own assets with below a certain minimum credit rating. All well intentioned, but it is no big surprise that such regulatory structure makes the ratings agencies highly influential.
Let's be clear what has happened. We - the public, that is - provide the social guarantees that allow finance to function properly: lender of last resort, limited liability, etc. We ask our governments to regulate this activity in order to protect us from the dangers that are inherent in a system of social insurance. Rather than take responsibility themselves for their judgements of what is prudent or not, these governments have outsourced prudence to ratings agencies. Maybe they were omnibulated by an ideology that the market aggregates information efficiently; maybe it was mainly the convenient corolloray, irresistible for a state that is hooked on the seignorial pretence of giving its voters something for free, that there is information in the system just for the taking. Whatever the reason, they outsourced the crucial element of judgement in prudential regulation - the piece that answered the question: "is this financial activity one that the public ought to underwrite"?
What, we might ask, is the point of government, if it is not to make difficult judgements? Anyway ... during the last thirty years, they have been unburdening themselves of these responsibilities with abandon.
Let's take a brief and satisfying walk down counterfactual lane: what would have happened if that critical function had not been outsourced? Ha-Joon has one sort of answer: he thinks we would "simplify the system and structurally reduce the need for the ratings agencies". In other words, we'd have a simpler financial system. That is certainly possible - and would have been welcome in the last 10 years.
But rather than prejudge the outcome of the judgements that would have been made, I would like to emphasise that without the agencies, we would have had a process for a public conversation - and public accountability - of what the financial sector was doing. If the job of judging the credit-worthiness of instruments were in the hands of regulators, rather than for-profit-agencies, there would have been a cadre of public servants looking in detail at what banks were doing. Instead, they assumed that the ratings agencies were doing the right job, and they could get on with the tasks they've been at for the past 30 years: finding something to sell off, or, as second best, outsourcing and unbundling some other aspect of public judgement.
Was it really so unwise to trust the ratings agencies to do a proper prudential job? As it happens, in the case of France's downgrade on Friday, they probably got it spot on: Krugman notes the irony of Standards and Poor's judgement that France is becoming a worse risk because of Europe's anti-Keynesian turn. There are two reasons why the ratings agencies were never going to be the right place for these judgements: one structural and one philosophical.
Structurally, their business model does not suggest truth-seeking behaviour. Here's an anecdote related to me by someone who had been CEO of a major City institution, one you would all have heard of. My interlocutor explained that he had had a visit from one of the big three agencies, one that was not currently rating their creditworthiness. "We'll do you a rating at a special price - say £200k". He took the proposal to his board, they considered the ratings that the other agencies were providing and declined the offer. Two weeks later, the agency's salesperson returned and said: "You know, we've decided to do a rating of you anyway. And from what I'm being told, our guys are coming up with a rating a notch below what you currently have out there in the market..." The message was clear: pay us and you'll get a better rating; turn us down and we'll break your legs - this was a protection racket. Honoroubly enough, my interlocutor and his board stood up to the Mafia tactics. But one way or another, the structural relationship is one that will never produce truth - at the very best, you need to read ratings through the prism of the strong-arm business practices that went into making them.
But more fundamental is the second problem with the rating agencies: if the thinking that really matters behind credit-worthiness happens at Standards and Poors, it does not happen in public institutions. So the argument that Krugman points to - is austerity bad for Europe's public finances? - is one that ought to be happening with all the force of the consequence in the European political space, not in a corporate research department.
So more than Ha-Joon's solution - the simplification of finance to the point where we don't need credit rating agencies - I look forward to the point where we have built our public service back to the point where it can make good judgement, even over matters of complex finance. Let the dark arts of finance flourish - but only in a context where we have effective and empowered public scrutiny.
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