Home > Economic policy > What to do about the ratings agencies

What to do about the ratings agencies

August 7th, 2011

S&P’s decision to downgrade US Treasury bonds from AAA to AA+ has elicited various reactions, some of which I’ll doubtless repeat here. Obviously, S&P has no particular expertise (apparently it couldn’t even get the arithmetic right) and based on its historical and continuing performance, its opinions ought to carry no particular weight with anybody (they say so themselves, when under pressure over obvious cases of misrating, asserting that they are merely offering an opinion).

On the other hand, it’s also pretty obvious (and even more so after the Repubs successful use of the debt ceiling to force Obama to abandon any call for tax increases along with the cuts they both wanted) that the US has some fairly intractable problems in dealing with its (technically quite manageable, but still substantial) public debt. Finally, as I said last time I discussed this, a decision of this kind (including a decision to maintain AAA ratings) is inherently political

There are two reasons why S&P’s choice of rating matters more than, say, my own opinions on the matter
* First, a lot of investors still pay attention to ratings agencies, for whatever reason
* Much more importantly, agency ratings are embedded in global regulations concerning prudent management of investment. If a second major agency were to join S&P in downgrading, large numbers of institutions would be debarred, under existing rules, from investing in Treasury bonds

That’s clearly unsustainable, so what will happen?

All sorts of fudges are possible, but the only clean response is to remove reference to private agency ratings from regulations prescribing prudent management of investment. Under current rules, provided managers invest in AAA-rated assets they are normally regarded as having discharged their duty of care. On the other hand, the agencies insist that their ratings are mere opinions, and that they have no duty of care whatsoever in offering them. Dodd-Frank was supposed to fix this, but as I just discovered (H/T Anders Widebrant), the SEC has abandoned any attempt to implement this part of the law.

But what is the alternative. I (and others) have previously floated the idea of a public ratings agency, but I now think this is a roundabout and inappropriate solution to the problem of defining a safe harbor for institutional investors. What is needed, simply, is a list of approved investments drawn up by the relevant regulators. Investors who choose assets outside this list would do so on the basis of their own judgements and would have to defend that judgement in the event of default.

There are some crucial differences between this and the existing system. First, regulators take responsibility for their own decisions, rather than outsourcing them (though some may choose to use a common list). Second, and most importantly, this approach reverses the onus of proof regarding financial innovation. If someone comes up with a new financial instrument, and a theory as to why it is (almost) risk-free, they have to persuade regulators (who will carry the can if something goes wrong) to approve it. Under these circumstances, the kinds of institutions that are required to make prudent investments will be effectively excluded from investing in innovative instruments. Given the history of financial innovation, that’s a good thing.

There are still problems here. Lots of governments have AAA-rated debt and lots more would like their debt regarded the same way, even if (or especially if) they are not pursuing particularly prudent fiscal policies. Obviously they would like, and will pressure, regulators to take a favorable view, and will be particularly miffed if their debt is dropped from an approved list. There are several cases here. One is the case where the regulator is responsible to the government concerned. In that case, I think nothing can be done or should be done. The government will declare that someone who invests in its own securities has done nothing wrong – institutions regulated by that government will have to make up their own minds whether or not to do so. The second case is that of the debt of foreign governments – here a downgrading might involve some embarrassment, but as long as it is done by independent regulators. The third, and trickiest case is that of regulation in a federal or confederal system (US states or EU member countries). I haven’t thought through this one yet, so I’ll leave it for comments.

What would happen to the ratings agencies if they were cut out of the regulatory loop? I’d guess that they would continue the business of rating ordinary corporate debt, much as before, but they would lose a lot of business associated with rating innovative financial instruments (given their record of failure in this area) and government debt (given that they would be competing both with regulators and with CDS markets).

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  1. Eli
    August 7th, 2011 at 15:29 | #1

    There is still the question of how much credibility a list drawn up by the regulators would have with investors, partly for reasons you refer to in the post. The only way this can be resolved fairly is by having someone put out an alternative list, in which case we are back to having to have independent rating agencies.

    The trick here is to make sure these agencies operate on a competitive basis. Those that produce flawed ratings would lose credibility and over time go out of business. Divergence in opinion across the agencies is a good thing from this perspective (and something a ‘list’ would not achieve’): S&P moving out of line with Moody’s and Fitch is a healthy development actually, for example. Preventing competitive pressures from taking place by enshrining ratings in regulation and investment mandata is the big problem here.

  2. August 7th, 2011 at 15:30 | #2

    Pr Q said:

    What would happen to the ratings agencies if they were cut out of the regulatory loop? I’d guess that they would continue the business of rating ordinary corporate debt, much as before,

    ie they would get a real job and work for a living instead of trying to sell the Brooklyn Bridge to greater fools or acting as straight-men in the GOP’s latest political comedy routine.

  3. PSC
    August 7th, 2011 at 16:14 | #3

    Dear JQ,

    I think the solution is simple; take rating agencies at their word. When they say that they just collect some data and offer opinions, give them exactly as much credence as anyone else who just collects data and offers opinions.

    This should obviously apply to legislation as well.

    But if a financial institution wants to outsource its credit department, let them, to some institution which accepts liability – i.e. which is not a CRA. Currently the “regulator and taxpayer” are effectively acting as a deposit insurer for our banks. Let that continue for a tightly defined and well understood collection of loan classes, e.g. resi mortgage. But for other loans, an outsourced credit department should also have outsourced capital.

  4. Ikonoclast
    August 7th, 2011 at 16:15 | #4


    The system you recommend has already been tried and it has already failed completely and utterly. That system AAA-rated junk bonds and junk credit default swaps in the lead up to the 2008 Financial Collapse. The only competition the credit rating agencies were involved in was a race to the bottom to rate clients (who paid them) the way the clients wanted to be rated. The credit rating agencies have precisely zero credibility. Zip, zero, nada, none.

  5. Ernestine Gross
    August 7th, 2011 at 16:20 | #5

    IMHO, the existence of rating agencies are a crucial distinguishing feature between (dictatorial) capitalism and a market economy (mixed or otherwise).

    There is some amusement value in all this. There are people who simultaneously promote von Hayek and acquiesce the existence of rating agencies. Similarly, there are corporations who complain about union power (justified in some instances) while agreeing to jump as high as the rating agencies tell them to jump and paying for the said advice.

    IMHO, it is not a good idea to have compulsory superannuation without the law maker, the government, taking the direct responsibility for the investments. Alternatively put, I am not convinced that this direct responsibility can be delegated (to a ‘competitive’ market) by means of ‘regulation’, including lists allowable investments. These lists provide very useful information for the ‘big’ players in the financial markets.

    I propose the government is to simplify the rules for self-managed superfunds and to establish one national superannuation fund which has the same rules as those applying for retirement benefits of politicians.

    I agree with Jack S. regarding the future of the rating agency people.

  6. rog
    August 7th, 2011 at 16:33 | #6

    Super was seen as a necessary component to retirement but the reality is that funds have been used to bet on anything that moves while incurring management fees with the result that policyholders are left with diddly squat.

  7. August 7th, 2011 at 16:34 | #7

    Pr Q said:

    If someone comes up with a new financial instrument, and a theory as to why it is (almost) risk-free, they have to persuade regulators (who will carry the can if something goes wrong) to approve it. Under these circumstances, the kinds of institutions that are required to make prudent investments will be effectively excluded from investing in innovative instruments. Given the history of financial innovation, that’s a good thing.

    The phrase “financial innovation” should ring alarm bells in anyone whose money is “in custody”. Since when did the money changers ever leave a single red penny on the table for anyone but themselves? Hasn’t the two thousand year history of usury taught us to be wary of guys who play fast and loose with money. Oh yeah, I forgot, our ancestors were reactionary no-nothings who deserve only retrospective apologies.

    The ratings agencies were simply the errand boys of global capitalism. The idea that they should stand in judgment of the phonies they helped to create is another illustration of Muggeridge’s Law, reality always coming up with a more ludicrous scenario than any satirical pen could conjure.
    As Paul Krugman exclaimed: Really?

    As for financial innovation: after poking around ideologies for more than half my life – and finding that none of them really have the goods – I have come to the conclusion that there is nothing new under the sun.

    In a basic sense money is simply a bulk fungible good, subject to much the same economic laws as wheat or oil. ie it can be mass produced by government, warehoused by wholesale banks and traded by retail banks. Any money market tricks more than that should be treated with utmost suspicion: caveat emptor.

    Here is my offer to the ratings agencies, (apologies to Michael Corelone). They are just whores with a bad dose of the clap. They should get nothing.

  8. Ernestine Gross
    August 7th, 2011 at 16:37 | #8

    The Italian branch of S&P and that of Moody’s are in court in Italy as defendants.

    Source: Several international newspapers.

  9. fred
    August 7th, 2011 at 16:40 | #9

    Seen this?

    “Does Anyone at S&P Have Links to the Trader Who Bet $1 Billion That the U.S. Would Be Downgraded?”


  10. Freelander
    August 7th, 2011 at 16:43 | #10

    The American rating agencies continue to be a complete joke. The fact that it has taken S&P this long to downgrade US government debt is simply a disgrace. That the others haven’t yet is a greater disgrace. That the US government has not let Dagong Global Credit Rating Co enter their market is another disgrace.

    The US rating agencies seem to be almost an extension of US government policy to the extent of stretching beyond breaking point any credibility they may have had. Allowing bundles of junk CDOs to be rated triple A and distributed around the world facilitating the creation of the circumstances that gave rise to the GFC was beyond enough for them to have been put out of business.

    The US really needs to be heavied by other western countries to try to bring its behaviour back into line. Unfortunately due to its previous dominance and hegemony, western countries and their leaders still adopt an obsequious posture towards them.

  11. Eli
    August 7th, 2011 at 17:24 | #11

    Nope, this system has not been tried for the reasons JQ has elucidated: ratings are part of bank capital and other regulation, which leads to both a consistent pressure by banks on the rating agencies to converge on their opinions, and makes it impossible to ‘punish’ an agency for mistakes since the rating would still be required under the regulation.

  12. Eli
    August 7th, 2011 at 17:25 | #12

    I take it is an extension of US government policy for it to get downgraded.

  13. Freelander
    August 7th, 2011 at 17:36 | #13


    “seem to be almost an extension”

    First, only S&P has downgraded. Second, they would have all downgraded a long time ago, as for example, Dagong did, and would by now have downgraded them further, as Dagong has. if they were being evenhanded. (Even though I think Dagong, itself, is still giving them a generous assesment.) Dagong’s more evenhanded approach is a good reason the US government won’t let them into the US market.

    The US rating agencies seem to be almost an extension of US government policy but in reality they are more an extension of the US elite, who, by now, feel things are so desperate that they need to do the trifling downgrade to give the rabble in congress, an albeit slight, encounter with reality. Some of those in congress, the T party clowns, are so ‘other worldly’ that they daren’t risk exposing them to any full blown reality all at once, least the shock be to much!

  14. TerjeP
    August 7th, 2011 at 17:41 | #14

    Is there any evidence that regulators would be any good at doing credit ratings? Do they have skills, incentives, knowledge or insight that is lacking amongst other groups of human beings?

  15. Freelander
    August 7th, 2011 at 17:43 | #15

    At least the Chinese are finally telling the US to get its act together!

  16. sam
    August 7th, 2011 at 17:54 | #16

    I guess in this case a better question would be “Are they likely to do any worse?”

  17. Eli
    August 7th, 2011 at 18:09 | #17

    Why Sam? I’ve been over this on this blog before but if you actually look at the rating agencies’s record outside of subprime debt in the US (which a, ahem, notably rare exception), their record is quite good. Including sovereigns and mortgage paper in Europe and Australia for example.

    Freelander, #13, yes, Dagong is quite credible. The point I am making is that there are problems with rating agencies, but the S&P action yesterday is if anything a reflection that things are getting better, not worse. Given the their biggest critic is the US Treasury, it is a little difficult to make the case they are a tool of the US government. Elite’s is a much better point, admittedly, but then so is the whole financial system and we are talking about a wider issue regarding the finance-political complex than the rating agencies.

  18. Mulga Mumblebrain
    August 7th, 2011 at 18:44 | #18

    Why not just let the Chinese do it? Their system has proven vastly superior to the neo-feudal crony capitalism of the West over decades, and, in the case of corruption, standover tactics, shake-downs and assorted bankster villainy, that have bedeviled the West for years, they have a refreshing facility for condign punishment. In the West, of course, financial malfeasance, if one a sufficiently grand scale, is rewarded, not punished. Punishment is reserved for drones who cheat on their tax returns. The Chinese ratings agencies have recently downgraded US Treasury debt, for the rather ‘bleedin’ obvious’ reason that the ‘Greatest Country on Earth’ is insolvent.

  19. Mulga Mumblebrain
    August 7th, 2011 at 18:57 | #19

    Credit ratings agencies seem, in my opinion, to have acted a bit like News Corpse. Where News Corpse lets politicians know what it wants (tax cuts for the rich, greater exploitation of labour, favours for News Corpse etc)and makes examples of the recalcitrant, the ratings agencies let their ‘customers’ see the putative ratings about to be published (like waking up next to a horse’s head)then they ‘negotiate’ before publication. They also, as we know, facilitated the securitised assets racket with ratings that were mind-numbingly incompetent, or worse. And they are picking off euroland states one by one with downgrades, no doubt reaping huge rewards for those ‘prescient’ enough to have shorted those markets, and ending the threat of the euro replacing the US dollar as global reserve currency. As for downgrading the USA, who does that favour? Why the Republicans and the Tea Party belligerati, who want to destroy Obama, and find another excuse to squeeze out a few trillion more in cuts, targeting everyone but the top 10% or so, amongst whom one would undoubtedly find the ratings agency grandees.

  20. Freelander
    August 7th, 2011 at 19:10 | #20

    ‘merely offering an opinion’

    Judges and juries offer opinions after which people have been routinely taken away and hanged; yelling fire in a darkened theatre could be construed as offering an opinion; torture was facilitated in part on the basis of a (legal) opinion.

    The ‘simply offering an opinion’ defence is somewhat weak when those ‘opinions’ have foreseeable and dire consequences.

  21. sam
    August 7th, 2011 at 19:24 | #21

    They have a record of over-estimating the probability a government will default, and underestimating that probability for corporations. They also seem to be overly impressed by financial wizardry, and just apply the lazy heuristic “if it’s too complicated to understand it must be fool-proof.” As JQ mentioned, just in this last case of the US writedown, they were out by 2 trillion dollars. Such an organisation doesn’t inspire confidence.

  22. Ernestine Gross
    August 7th, 2011 at 19:28 | #22

    So, how do ‘we’ rate the rating agencies, S&P, M, F and Q on the following scale:

    AAA+ No default on opinion outlook positive

  23. August 7th, 2011 at 19:47 | #23

    Freelander @ #15 said:

    At least the Chinese are finally telling the US to get its act together!

    For those of us with a mordant sense of humour this is a moment to savour the rich irony of former coolies lecturing the sahibs on the virtues of prudence and good management. The PRC has simply retained the moral virtues that we lost when the WASPs went onto the endangered species list.

    I am continually struck by the maturity and responsibility of PRC’s attitude towards global finance. For one thing they keep their domestic financiers on a relatively short leash. Not so long ago they executed a securities trader for dodgy dealings. Whilst I am against capital punishment I do think that more draconian punishments for “financial innovation” should be meted pour encourage l’autres.

    Compare that to the USA where in the aftermath of GFC the Beltway fell over itself to bail-out Wall Street, shortly followed by “business as usual”Wall Street rewarding itself with obscene bonuses. Which “behaviour modification” strategy is more likely in the long run to achieve the desired result?

    More generally the PRC maintained stricter capital adequacy controls on local financiers to prevent them from building mountainous debt pyramids to leverage unearned income grabs. Given the historic propensity of Chinese people for having a flutter at the gambling den and lucky numbers, this strikes me as sound policy.

    Now the PRC has taken to lecturing the USA on the virtues of saving, as opposed to living on the never-never ending borrowing binge. The PRC is standing on a particularly solid part of the high moral ground here. China’s savings rate is fantastically high – approaching 50%. BIS working paper 312 reports that:

    there is little doubt that the Chinese national saving rate is high by international standards. It exceeded 53% of GDP in 2008, far above all the OECD economies and overtaking Singapore which has traditionally been among the highest savers globally

    I wonder how long the PRC will be willing to pour that surplus cash into US T-bonds when the $USD is on a long term secular decline (viz gold price). And the Congress is unable to crank up tax rates to actually, you know, raise revenue to pay the interest on national debt. ie a solvency and liquidity problem to boot.

    Meantime the PRC has taken up the role of global financial adult supervisor, pumping a massive quarter-trillion dollar fiscal stimulus into their domestic economy after the GFC when the US consumer went on strike and buying up “Eurotrash” PIIGS bonds when EU investors started to get jittery.

    The world needs a ruling class of people who are prepared to make sacrifices for the long-term. The baby boomers went out of their way to bury our WASP ancestors so I guess the CCP will have to pick up the torch.

  24. Charles
    August 7th, 2011 at 20:23 | #24

    August 7th, 2011 at 17:41 | #14
    Reply | Quote

    Is there any evidence that regulators would be any good at doing credit ratings? Do they have skills, incentives, knowledge or insight that is lacking amongst other groups of human beings?]

    Is there any evidence that rating agencies any good at doing credit ratings? Do they shown skills, incentives, knowledge or insight that is lacking amongst other groups of human beings?

  25. Fran Barlow
    August 7th, 2011 at 21:16 | #25

    The defence of the S&P downgrade by Felix Salmon below hardly relies at all on the kinds of economic consideration discussed above:

    Yes, there’s a lot of fiscal math in the S&P statement. But at heart, any sovereign ratings decision is political, not economic: the economics is there to provide a veneer of empirical respectability to what is fundamentally a value judgment. We saw the values of Congress during the debt-ceiling debate, including various members of the House who said with genuine sincerity that they’d actually welcome a default. In that context, S&P’s judgment is hard to fault.

    One might say that in that case, S&P regards the Tea Party as a sovereign risk issue.

  26. John Davidson
    August 7th, 2011 at 21:16 | #26

    The trouble with a single ” list” is that you are either in or out. It is a major incentive for pressuring, blackmail and government controls.
    At least the ratings have a number of steps going from good to lousy.

  27. damien morris
    August 7th, 2011 at 21:33 | #27

    At the heart of all this is the fact that finance (I use the term widely) is one of the few professions where practitioners are not held personally accountability for their actions. When did you last hear of a banker being barred from the profession for negligent or unprofessional conduct? If individuals in the various fields of finance, be it bank lending or credit rating agencies, were subject to the same sanctions as say doctors and lawyers, and could deregistered or disbarred for life then we might see a change in the behaviour of financial institutions. Until then failed bankers will simply swap jobs and governments will continue to step in to guarantee deposits.

  28. Ernestine Gross
    August 7th, 2011 at 22:18 | #28

    “The trouble with a single ” list” is that you are either in or out.”

    Well, yes. USA government paper is now ‘out’ of S&P’s AAA list.

  29. August 7th, 2011 at 22:29 | #29

    Mulga Mumblebrain @ #18

    Why not just let the Chinese do it? Their system has proven vastly superior to the neo-feudal crony capitalism of the West over decades…The Chinese ratings agencies have recently downgraded US Treasury debt, for the rather ‘bleedin’ obvious’ reason that the ‘Greatest Country on Earth’ is insolvent.

    I don’t believe the US government is insolvent – it still has valuable corporate and governmental assets. Rather the US is becoming financially ungovernable. The problem is getting the holders of these assets to cough up cash to service debt. Companies are hoarding cash overseas which puts it out of the reach of domestic shareholders. And governments do not seem willing to force high-income earners to pay higher rates of tax.

    I wonder how long the PRC will be willing to pour that surplus cash into US T-bonds when the $USD is on a long term secular decline (viz gold price). And Congress is unable to crank up tax rates to actually, you know, raise revenue to pay the interest on national debt. Eventually sufficient debt will pile up and turn the liquidity crisis into a solvency crisis.

    The PRC has taken up the role of global financial adult supervisor, pumping a massive quarter-trillion dollar fiscal stimulus into their domestic economy after the GFC when the US consumer went on strike and buying up “Eurotrash” PIIGS bonds when EU investors started to get jittery.

    I recall Chinese treasury officials complaining about QE, which caused the $USD to tank and obviously eroded the value of their T-bond holdings. The Chinese rating agency downgraded the $USD as a consequence.

    The United States has lost its double-A credit rating with Dagong Global Credit Rating Co., Ltd., the first domestic rating agency in China, due to its new round of quantitative easing policy.

    Dagong Global on Tuesday downgraded the local and foreign currency long-term sovereign credit rating of the U.S. by one level to A+ from previous AA with “negative” outlook.

    The Chinese rating agency said the downgrade reflected the U.S.’s deteriorating debt repayment capability and drastic decline of the U.S. government’s intention of debt repayment.

    “The serious defects in the U.S. economy will lead to long-term recession and fundamentally lower the national solvency,” Dagong said in a report.

    The Chinese rating agency said the Federal Reserve’s new round of quantitative easing would further depreciate the U.S. dollar and was entirely counter to the interest of the creditors.

    The US has decided to screw foreign, rather than domestic, holders of US debt. Perhaps the Chinese are buying up gold instead, out of distrust for the dollar and euro?

  30. Ikonoclast
    August 7th, 2011 at 22:48 | #30

    @Jack Strocchi

    Exactly. In a very real sense the US is defrauding the rest of the world. I think at the plutocratic level it is deliberate policy. However, in wrenching the golden egg out of the innards of the goose they will kill the goose.

  31. Freelander
    August 8th, 2011 at 09:44 | #31

    Whatever the track record of the US ratings agencies in other cases, the ratings they gave for vehicles designed to get rid of the CDOs were just silly, and quite possibly motivated by the commissions they were earning, and if not motivated, the money probably clouded their judgement.

    The ratings they have given and are given of US government debt are just silly as well. In this case their ratings have probably been coloured by a number of factors including, misplaced patriotism, misplaced belief in American exceptionalism, and a good understanding of the savaging they would and S&P has received were their ratings a bit more reality-based.

    Question is, will it be off to Gitmo for the S&P analysts? Or are they only preparing accommodation for the likes of Julian Assange?

  32. KB Keynes
    August 8th, 2011 at 10:53 | #32

    It appears S&P made a mistake in their calculations.

  33. Mulga Mumblebrain
    August 8th, 2011 at 11:08 | #33

    Jack Strocchi I believe that the US is functionally insolvent. Its debts are gigantic, much of its ‘assets’ eg infrastructure, is crumbling, and too much is bound up in the archipelago of military bases and expenditure, which will soon have to be written off. They are close to losing their decades long scientific-technological dominance, their education and health systems are disgraces, their popular culture is violent, pornographic, misogynistic, racist and Philistine and their political, business and media leadership is beyond parody and beneath contempt. On infrequent polling of public opinion around the world, the levels of detestation of the US have been steadily rising for years, due to US arrogance, hypocrisy and violent belligerence. So, in my opinion the US is morally, spiritually and politically insolvent. The question of assets via liabilities in economic terms might also, by now, fit my hypothesis, particularly in regard to financial assets, much of which will, I believe, vanish like morning mist when the great deleveraging hits top speed. Moreover, as figures on wealth distribution indicate, in the US something like 90% of the population are functionally insolvent. From 2005 to 2009 the wealth of black and Hispanic households, never much apart from their homes, fell by 66% and 55%. With their unemployment rates that indicates that those communities (and I’ll wager poor whitefellas too,)are enduring a Depression akin to that of the 1930s.
    Ikonoclast, of course the US is defrauding the world, and deliberately so. ‘Helicopter’ Ben Bernanke cranks out a lazy trillion or so of new US dollars with a tap of a keyboard, and that money, rather than being invested in the US, goes to the financial grifters for ‘business-as-usual’. More gigantic fees and bonuses, more loot for hedge and wealth funds to speculate and blow up bubbles in commodities, and to launch raids on euroland bonds. More money to flood China and drive up inflation there, or swamp Brazil and drive up its currency. Who was it who said, back in the 1980s in the Reagan era of financial incontinence, ‘It’s our dollar but your problem’ to the rest of the world? In 1985 the US was able to impose the Plaza Accord on the puppet Japanese regime, but such an act of economic seppuku will not come from the Chinese.

  34. Ian Milliss
    August 8th, 2011 at 12:20 | #34

    @Eli @17
    Isn’t that a bit like saying he was a perfect husband and father except for the one occasion when he murdered his wife.

  35. may
    August 8th, 2011 at 13:52 | #35

    idiot alert:

    the size of the aknowleged (taxed or dodging tax)world economy is (apparently)equaled by the unaknowleged world economy untaxed and moving invisibly through financial conduits via laundering and haven availability.

    what blind bit of good does any ratings agency do in the face of information black holes and unaknowleged blind spots?

  36. August 8th, 2011 at 14:00 | #36


    How did the ratings agencies perform during the run-up to the following stock market crashes:

    – dot.com (NASDAQ)
    – telcoms (Enron et al)
    – sub-prime (WaMu, CoWi)

    We both know the answer – they all went along for the ride whilst the going was good. Who pays the piper calls the tune.

    Its not as if this is a wild departure from normal behaviour. Ever since the early eighties fiancial de-regulation its been one episode after another of financial chicanery, basically a generation long white collar crime wave.

    With how many crooks doing the perp-walk? Madoff is doing some easy time after his affinity fraud. But the hedge-fund honchos managed to get the scalp of Spitzer just in time. Thats not what I call justice.

    Sure, I know that the weak version of Efficient Markets means that picking stock market fluctuations is a mugs game. I agree, although a stochastic random walk is not what most people think of when they hear the term “efficient”.

    But these equity bubbles were caused by financial fraud, not factoral upheavals. Thats the sort of thing that ratings agencies are meant to pick up, by pursuing due diligence with the books, in concert with the Big Four accounting firms.

    However it turns out “they” (the Wall Street-Beltway axis of evil) were all in it together – ratings agencies, auditors, investment banks, shadow banks, Fannie Mae/Freddie Mac, the Fed and, of course, the White House.

    Proving pretty convincingly that financial elites aren’t really in charge of the ship, they are just minding the shop whilst all the time plunging their hands into the till. They are all whores, but with no happy endings to the transaction, so to speak.

    Like I said back in 2003, there is really no way to reform the current system with the current persona in position. Whats required is a clean sweep with a new broom:

    There clearly needs to be a tax/regulatory impediment to financial “casino capitalising” or some sort of purge of the finance class.

  37. Freelander
    August 8th, 2011 at 15:02 | #37

    Repaying Government debt, in a developed country, before it becomes so bad that it is not still technically quite manageable, is a political problem. In democratic countries, it is a problem with the electorate and the elected. A downgrade (and more) was fully justified because the US has these problems and has had them for some time, and does not look like it will get rid of these problems any time soon. Like Greece, a significant and influential part of the electorate doesn’t believe they should pay taxes, and seemingly, doesn’t believe they should have to repay government debt. Like Greece they will suffer consequences. Unfortunately, we are also.

    For too long the rest of the world has been subsidising the US through the US’s ‘exorbitant privilege’. That privilege must be finally be coming to an end.

  38. NickR
    August 8th, 2011 at 15:45 | #38

    This is a serious question and deserves a serious answer.

    While it is clear that regulators may face bad incentives I can think of a couple of reasons why ratings agencies also may not do a good job. Of course these are only candidate explanations and may or may not be correct, however I think they are sufficiently strong to merit some examination.

    1. Principle agent problems. Suppose that the management of a ratings agency has a stronger ideological motive than profit motive, and that due to P/A problems the management is able to pursue their ideology at the owner’s expense. Information asymmetries between owners and managers come into play here.

    2. The job of the ratings agency could be modelled as an iterated game with the government, investors and the public as other players. We all know that prisoner’s dilemmas and other problems frequently exist in such games and thus the agencies may have the legitimate incentive to misrepresent credit worthiness for strategic reasons. For example it is quite plausible that agencies might deliberately seek to harm an administration that they feel might seek to tax or regulate them, resulting in great harm to the country as a whole.

    The burden of proof is on me to show that either of these scenarios actually applies, which is something I don’t have the time or expertise to do. However this should demonstrate that the knee-jerk idea that only governments face perverse incentives is wrong.

  39. Freelander
    August 8th, 2011 at 15:57 | #39
  40. JoshD
    August 8th, 2011 at 16:12 | #40

    Oh, so this is where the decent conversation has got to now that local has been overrun by the pokies!
    Great post as always JQ, and terrific comments.

    Somehow these guys have to be held to account, or at least stop lecturing the world on the superiority of Republican capitalism. If the movie Inside Job is even half accurate, their current positions suggest that’s not going to happen any time soon. Yup, Jack S, China is looming more and more as our best economic friend, and who knows now perhaps even our policy parent. Nup, Damien M, “finance” isn’t a profession, for the absence of the very self-regulation you mention. Far from it, alas!

  41. damien morris
    August 8th, 2011 at 20:57 | #41

    Thanks for the comment JoshD. It doesn’t matter what you call it although I think some of the people at Macquarie Bank might like to debate you on that. But the bottom line is that the problems associated with the finance industry generally are all too clear. Here’s a fun fact. According to the ACCC the Australian Council of Professions defines a profession as:

    ‘A disciplined group of individuals who adhere to high ethical standards and uphold themselves to, and are accepted by, the public as possessing special knowledge and skills in a widely recognised, organised body of learning derived from education and training at a high level, and who are prepared to exercise this knowledge and these skills in the interest of others.

    Inherent in this definition is the concept that the responsibility for the welfare, health and safety of the community shall take precedence over other considerations.’

    Wouldn’t you like to think that when you speak to your friendly banker (or read a rating agency report) that the above standard (reinforced by appropriate sanctions for breaches) would apply.

  42. Freelander
    August 9th, 2011 at 01:45 | #42

    @damien morris

    Sounds like a definition of a (labour) union. Amusing that to get flexibility in the labour market the ‘reformers’ went after those unions, the ones that don’t call themselves professionals, first; and then stopped from going further. The isn’t much ‘flexibility’ when it comes to those unions called the professions, or that aspire to be thought of as professions.

  43. Mulga Mumblebrain
    August 9th, 2011 at 06:38 | #43

    With the Dow down 600 points it looks like the ratings downgrade has worked nicely. The pressure on the budget slashing ‘bi-partisan’ committee will now be overwhelming to hit the poor and middle even harder. ‘Disaster capitalism’ in action, with ‘umble Uriah Obama wringing his hands in a pose of impotent angst. He’s right ‘though-the USA remains a ‘AAA’ country. In violence, oppression, murder and intimidation they remain, as ever, ‘world class’. In income inequality, elite arrogance and social sadism, they’re still Number One-and don’t you forget it!

  44. gerard
    August 9th, 2011 at 08:10 | #44

    Inherent in this definition is the concept that the responsibility for the welfare, health and safety of the community shall take precedence over other considerations.’

    Wouldn’t you like to think that when you speak to your friendly banker (or read a rating agency report) that the above standard (reinforced by appropriate sanctions for breaches) would apply.

    Haha, good one, Damien!

  45. Freelander
    August 9th, 2011 at 08:36 | #45

    Can the poor be squeezed any more? The pips squeaked long ago.

  46. gerard
    August 9th, 2011 at 09:10 | #46

    During the Great Depression, FDR threatened to stack the Supreme Court to get his way. Compare this type of radical Constitution-pushing action to the “bipartisan” Obama, who has said that even in the face of an unprecedented default he will not exercise the 14th amendment, which suggests that the whole debt ceiling is actually unconstitutional. There’s a good chance that behind the Republican leadership’s willingness to play chicken was the underlying belief that Obama would, in the end, simply avoid default using the 14th (which they would then use as a pretext for ridiculous impeachment proceedings). However I think that this downgrade happened because this debacle has been the first time that the 14th amendment has been raised as an option, and Obama has unequivocally taken it off the table, setting a precedent for the rest of his term, and for future administrations.

    This means that Teabaggers, who (through the threat of primary challenges) control the GOP, who in turn (through the abuse of the filibuster) control Congress, have become genuinely dangerous to Wall Street’s interests, and can no longer be regarded merely as useful idiots. This faction would genuinely welcome a default, because they are true revolutionaries who believe (as Keynes said of Lenin) that the best way to bring down the system is “to debauch the currency”. The ensuing economic chaos and government bankruptcy will presumably be blamed on everyone except the Tea Party, who the grateful population will then empower to restore a late-nineteenth century sized-government with a gold-backed dollar.

    Now when you have one party that is controlled by people who genuinely want to bankrupt the government, and the other party is controlled by a President unprepared to test the only constitutional tool at his disposal, there is a very real prospect that next time there’s a Debt Ceiling debate (by which time the GOP might be even more extreme than it is now) the type of compromise that was reached this time around won’t happen. Like a game of chicken in which one car doesn’t have a driver inside, either they crash, or the Democrats will be forced to yield completely. If the Democrats yield, destroying Social Security and Medicaid, then the government spending cuts will contract what little economy activity there still is, causing further depression, probably decreasing tax revenue and causing deflation, and ironically worsening the deficit. If the Democrats don’t yield (or they try to yield but the Tea Party continually shifts the goalposts) then the debt ceiling is hit and in order to continue paying out interest on bonds the government will have to shut down many of its functions and start scraping random pennies together, or request the Fed to start printing money like crazy. Yields will rise and either the government defaults or hyperinflates its way out of debt.

    This type of thing used to be unthinkable and that’s why treasuries were AAA. It isn’t unthinkable anymore since American politics has become truly insane. The real question is whether or not the GOP has hit peak-Wingnut and starts to moderate over the 2012 cycle. But even if they do, it’s too late for America. The GOP (Norquist) plan, all along, was to bankrupt the country so that social programs had to be cut and so that no Democrat could govern as a Democrat. When Bush came to power, Clinton’s surplus was viewed as a problem that had to be dealt with. Even if the Democrats somehow get a filibuster-proof majority in Congress and manage (somehow) to balance the budget over the coming years, it will all be deliberately undone by the next Republican government, and this cycle will happen again and again as long as the GOP exists in its current form, or even a vastly more moderate version of its current form.

  47. gerard
  48. damien morris
    August 9th, 2011 at 18:35 | #48

    Gerard I agree entirely – very well put. This is about power at any cost.

  49. gerard
    August 10th, 2011 at 08:46 | #49

    August 25, 2001:

    President Bush said today that there was a benefit to the government’s fast-dwindling surplus, declaring that it will create ”a fiscal straitjacket for Congress.” He said that was ”incredibly positive news” because it would halt the growth of the federal government.

  50. Mulga Mumblebrain
    August 10th, 2011 at 11:10 | #50

    gerard, an eloquent and convincing argument. Prediction, particularly of the future, is difficult, but I would not be at all surprised if things turn out ore or less as you say. We know that the Tea Party Mad Hatters are pretty well financed by the Kochtopus, ie by extreme Right ideology that would, ironically, worsen the situation of the lower middle class Mad Hatters quite considerably, but everyone, no matter how intellectually challenged or morally compromised gets a vote. In the US it’s just a matter of getting them out on polling day, and rage, paranoia, downward envy and sheer hatred of others are powerful tools to ‘incentivise’ the mob.
    If the Mad Hatters are a Frankenstein monster now running out of control, we might see a delicious irony in it bringing down the house of cards. But, what if that is what the controllers actually want? After all the rich generally do well during Depressions. Black and Hispanic households have already suffered Depression era falls in wealth over recent years, while the elite has been shoveling it in. What if a new Depression was being engineered to justify some wide-ranging social re-organisation towards a more open and brutal, fascistic, rule by the moneyed oligarchies? What if there is method in their madness?
    I still think it more likely that the situation has been building for some time, say from Nixon’s abrogating of Bretton Woods, and that is now basically out of control. Economic collapse, at root caused by elite greed, growing inequality and wage stagnation driven rocketing household debt, has the US by the throat. At the same time resource depletion, specifically Peak Oil, has arrived, and any meaningful recovery in Western demand will send prices through the roof. Ecological collapse is kicking in, complicating matters, driving food prices up, and fomenting social unrest even in loyal satrapies of the US Empire. And US imperial overstretch gets daily worse, with several military aggressions, Special Forces death-squads assassinating, kidnapping and torturing across the globe, and Russia and China increasingly confronted by US belligerence. The mindset remains that of the universal global hegemon who demands obeisance from all, with one exception-Israel.
    And Obama is, and always has been, a loyal functionary of that global empire. His does what he is told, and the debt ceiling pantomime was simply an act put on to justify destroying Social Welfare and entitlements. Obama always surrenders to the Right, after some mock defiance, his head held high, slightly turned to one side, as if in direct contact with the All High. The chap’s self-delight is priceless. Then he caves, once again, and yet the Hopey-Dopey suckers keep coming back for more,

  51. Sam
    August 10th, 2011 at 11:42 | #51

    I think it’s usually a mistake to posit a conspiracy theory when ordinary incompetence will do.

  52. Freelander
    August 10th, 2011 at 14:19 | #52


    There is no real conspiracy. Numerous members of the looney right have, at various times, stated that constraining government’s ability to tax is a great way to shrink the size of government. Loading the government with debt so that the only spending can be repaying the debt is simply a variation on the theme.

    Sure they are incompetent but they also have looney beliefs including that a modern economy can operate with a very small government. These beliefs underpin their lack of concern about bringing the world economy to the brink of disaster, because in their alternative reality that is not what is happening, and if it does happen, it wouldn’t be their fault.

  53. sam
    August 10th, 2011 at 14:28 | #53

    I agree with that. I was replying to Mulga’s assertion here:

    And Obama is, and always has been, a loyal functionary of that global empire. His does what he is told, and the debt ceiling pantomime was simply an act put on to justify destroying Social Welfare and entitlements. Obama always surrenders to the Right, after some mock defiance, his head held high, slightly turned to one side, as if in direct contact with the All High.

    Obama may be weak, he may be too centrist, and he may have a silly obsession with bipartisanship. He is not however, in on a vast conspiracy. He is bad at being a good president, not the other way around.

  54. Freelander
    August 10th, 2011 at 16:30 | #54

    I agree Obama isn’t in a formal conspiracy but he, like other politicians, is well aware of the vastly easier path he treads by keeping in with the so-called establishment. He is just one more ‘modern’ politician driven not by principle or the desire to achieve but rather driven by the desire to be elected, in this case elected and re-elected President. The desire is too accumulate political capital not to spend it. He prefers the easy life. After all he has a Nobel Peace Prize, for which he did and has done nothing, why should he have to do anything at all?

    One factor contributing to the current riots in the London at the moment is probably the sense of alienation large sections of British society now feel after the many years of Thatcherism and ‘New’ Labour. Society is not set up to serve any of their needs let alone desires; clearly it is set up for those somewhat better off. Because society has abandoned them, it is unsurprising that they feel no allegiance to that society.

  55. sam
    August 10th, 2011 at 17:01 | #55

    Agree completely.

  56. Ernestine Gross
    August 11th, 2011 at 09:58 | #56

    What to do about the rating agencies? Start with selling McGraw-Hill Inc. securities and don’t buy their Finance texts. http://www.nyse.com/listed/mhp.html

    There is a finance war on.

    Latest examples: Warren Buffet bought 40 billion $ worth of US government paper and made a public statement against S&P. S&P respondend by down-grading the papers issued by companies associated or controlled by Buffet.

    France government paper is now under attack and French banks are ‘down-graded’.

    Hopefully the French will follow the lead of two Italian NGOs and take S&P to court for market manipulation.

    It is absurd to have a bunch of people who ‘rated’ junk bonds as AAA investment bonds and have them sold all over the world to now dictate to the world how they are to pay for their mess.

    The market manipulation is too obvious.

    This has gone far beyond debates. This is serious.

    PS: The Chinese advice to the USA government revealed a lot about China’s concern with the welfare of people. Not impressive IMHO. Either the Chinese are going to make their currency tradeable or ‘we’ will have to reintroduce tariffs. End of story.

    In a sense it is quite amusing to have two or more ‘leading’ country governments trying to pursuade the rest of the world that their problem is the problem of the rest of the world.

  57. Mulga Mumblebrain
    August 12th, 2011 at 18:40 | #57

    I read today that US banks have been ‘instructed’ not to lend to French banks. If true it gives credence to my current pet conspiracy theory (well, my favourite amongst many) that the wealth and hedge funds’ assault on the Eurozone countries’ bonds, one after the other, is part of a US campaign to destroy the Euro. After all the threat of a rival to the US as global reserve currency would be seen by the ruling US elite as a ‘New, New Pearl Harbor’ worthy of an exemplory exercise of economic ‘Full Spectrum Dominance’.

  58. Freelander
    August 12th, 2011 at 19:03 | #58

    The US has been vigorously trying to distract the world from their problems and to stop the logical dumping of their currency as the world reserve in favour of the Euro (which should have taken place at least five years ago). Who would you trust to manage the world reserve currency, the US government and their feral Fed or the ECB?

    That US intelligence agencies have had a hand in trying to undermine confidence in EU countries, the Eurozone and the Euro should come as no surprise. After all, whose intelligence agency overthrew the democratically elected government of Iran in 1953 in favor of the Shah and in favor of the West getting their hands on the oil? Who attempted to overthrow Castro and assassinate him several times? Who overthrew Allende? And who had a go at overthrowing Chaves? Why would they not purse ‘American interests’ in Europe?

    When will our traitorous leaders in the West recognise that the US is not our friend?

  59. Beau Smyth
    August 13th, 2011 at 18:21 | #59

    Tthese ratings agencies charge a bucketload for their supposedly objective opinions. How is that different a pharmaceutical company paying for ‘independent’ assessment of dodgy drugs?
    If it weren’t for the ratings agencies’ endorsement of junk securities (by an entirely different, but not-much publicised ratings methodology, ie, AAA on a sovereign is nothing like AAA on a junk mortgage security), would we even be in this economic shambles now? I think not.
    John, you are right. It is time that the spurious authority of the billion-dollar ratings agencies was submitted to the junk pile with the junk bonds they loved to death.

  60. Mulga Mumblebrain
    August 13th, 2011 at 18:36 | #60

    The answer to your question Freelander is ‘never’. We are a totally subservient vassal of the US/Israel Global Empire. Not only would an even marginally independent leader get the Whitlam treatment, with today’s equivalent of Marshall Green appointed as US Ambassador, and any number of the hundreds of US intelligence ‘assets’ in the upper ranks of our ruling class be mobilised to do ‘their duty’ for ‘Western Civilization’, but the Australian elite has also auto-selected over decades for extreme, groveling, sycophancy to the Real Evil Empire. The address by Gillard to the US Congress was just about the most demeaning and embarrassing display of obsequious and emotionally incontinent brown-nosing I have ever seen, or hope ever to see. And, according to Ron ‘Creosote’ Boswell in yesterday’s ‘The Fundament’, it came from a fully paid up (in ‘Moscow gold’ no doubt) member of the Comintern. Indeed, when you think of it, it would defeat the most inventive and sardonic comic writer to create a polity such as ours, so far does it dwell ‘beyond parody’..

  61. Freelander
    August 13th, 2011 at 19:16 | #61

    @Ernestine Gross

    The US is not our friend. The West really needs to get together to protect itself from the US because they have been robbing us blind for years. Do they really need the secret army called the CIA with a secret budget and an estimated 20,000 employees, not counting contractors. And the secret budget doesn’t count their off budget money which they have been earning for years through drugs and arms running so that they are not under congressional or presidential control. How many remember that in the 1980s the CIA successfully had newspapers reporting that the Iranians were gassing the Iraqis? Of course, the truth was in the newspapers when the US decided to go to war with Saddam.

  62. Ernestine Gross
    August 15th, 2011 at 17:33 | #62


    But I have many friends in the USA.

    I hear what you say, Freelander. I am merely an economist and, to make matters worse, I am one of those who is interested in the welfare of people and in their ‘freedom’ (as understood in a social democratic framework, which I interpret to include freedom from brainwashing). All insights I could get from my studies and work in the alledgedly dreaded area of theoretical models of ‘competitive private ownership economies’ lead me to one conclusion: The existence of rating agencies is inconsistent with the idea of a market economy. The rating agencies belong to a dictatorial system.

    The good news (relatively) is that Berlisconi figured out which side of his bread is buttered. The Italian ‘austerity’ program includes a 5% tax for 2 years on incomes above Euro 90,000 to Euro 150,000 and a 10% tax on incomes above Euro 150,000 – to get funds from the ECB. (Source: smh and some EU press). I also read that Switzerland considered temporarily pegging the sfr to the Euro (apply Lucas’ notion of rational expectation to this one to get interesting implications).

  63. Freelander
    August 15th, 2011 at 18:58 | #63

    @Ernestine Gross

    They are probably victims too. It is the US establishment that is not our friend. They are hardly the friend of 90 per cent of their population either, given how their income distribution has gone. With one grandparent born there and knowing plenty of good Americans, I don’t think the entire population can be written off. Sadly, those who have been running the place may be paving the path to its destruction, and an upheaval which could be far more dangerous than the collapse of the Soviet Empire.

    I was surprised and heartened that Berlisconi (of all people) did what ought to have been done in many other countries, which is institute an austerity program targeting those how benefited most from the good times. One additional aspect of such targeting which also makes it more desirable is that the marginal propensity to consume tends to be smaller at higher incomes.

  64. Freelander
    August 15th, 2011 at 19:00 | #64

    The Swiss pegging was also a good and obvious move.

  65. Mulga Mumblebrain
    August 15th, 2011 at 20:42 | #65

    Ernestine, a ‘market’ economy, by which I assume you mean a market capitalist system, is itself a dictatorship- of money. Market capitalism operates under the principle of ‘one dollar, one vote’ so becomes, as we can see, a dictatorship of the rich. A true market system would entail equality of wealth, so that we could all have an equal go. Also, for the sake of moral hygiene, all those lovely exploitative processes by which unscrupulous capitalists rob others of their wealth ought to be banned. Then, with no avenues for pointless displays of egomania and contempt for others, most economic activity, certainly nearly all ‘financial’ manoeuvring, would cease. People would live with a decent sufficiency, and displays of conspicuous excess would become steadily more difficult. This economy would tend to a steady-state, and have the rather grand consequence that we would thwart the neoplastic ecological doom that our current system is bringing about at breakneck speed.

  66. Ernestine Gross
    August 15th, 2011 at 23:24 | #66

    Mulga M., your assumption about what I said is wrong. I do not accept an equivalence between theoretical models of ‘competitive private ownership economies’ and ‘capitalism’.

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