Tougher rules on Credit Rating Agencies are not enough

2013-01-18

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Financial ratings of European States by Standard & Poor’s Picture credit: Wikipedia

This week the European Parliament adopted a resolution which decisively restricts many of the operations of Credit Rating Agencies (see provisional edition of the final text). Ever since the beginning of the Great Recession, roughly five years ago, Credit Rating Agencies have been regarded, correctly or erroneously, as the culprits of the financial and economic crisis that befell humanity. The overall narrative underpinning this decision was that these private agencies held substantial market power, since their ratings were the single most important determinant in shaping the portfolios of investors. Collateralized debt obligations and other toxic financial derivatives were branded as “risk-free”, courtesy of the excellent ratings from the triad of Standard & Poors, Moody’s and Fitch. Price signals and other underlying factors were thus obfuscated or severely distorted, effectively engendering egregious malinvestments and resulting in heavy distortions in the capital structure. A great deal of truth can certainly be found in all these views and, in that respect, the European Parliament’s resolution is a step in the right direction. Nevertheless, much of the broader picture has been brusquely ignored, wittingly or not, in what has become a post-modern witch hunt against financiers and market actors.

In particular, politicians and opinion molders were spot on in their accusations of the graft and ethical frailty inherent in the modern financial system; and they were also correct in stressing the oligopolistic status and excessive market power of the three major rating agencies. Where they failed lamentably, was in not pointing out the set of fiscal, monetary and regulatory policies that fostered this situation of corporatism, cronyism and corruption. Their pontifications omitted the fact that these agencies were impregnated by the chimerical policies of the “Great Moderation”, viz. those economico-political views that stem from the neoclassical synthesis of mainstream economic thought and which in effect advocate the ‘management’ of the economy through the combined efforts of government and established corporations. What the uninformed refer to as “free market” is nothing but a neo-mercantilist system ruled by the invisible iron fists of big government and big corporations; this system has nothing or very little to do with the principles of genuine competition, free exchange and voluntary cooperation.

Credit Rating Agencies enjoyed an official oligopolistic status and their ratings were treated by official entities—with the European Central Bank being one of them—as cardinally important indicators in the assessment of risk and evaluation of assets. In other words, policy-makers used such credit ratings to conduct their ‘public’ policy.

Largely thanks to the misguided Basel Accords on capital adequacy, which have managed to produce this magnificent phantom of ‘zero-risk’ assets, these rating agencies could determine which assets were to be considered safe or not; and could, by that account, channel resources in any way they wished to, merely by providing their patina of authority, found in their top ratings (I recommend reading the excellent analysis of fellow blogger and economist, Vuk Vukovic: Political economy of the US financial crisis 2007-2009).

In a nutshell the awesome power these “big three” had, was offered to them with alacrity by public institutions and authorities. Thus a fair assessment of the subject now under discussion must point to the fallacious assumptions that are omnipresent in modern politics. These are most often made manifest in laws that insulate certain corporations from genuine competition, by increasing barriers to entry, or by directly providing privileges and sweetheart handouts shrouded in public-private joint ventures; or occasionally, when things allow or call for it, in pseudo-patriotic and quasi-socialistic palaver which presents such cozy relationships as benign for “the homeland”, “the people”, “the nation” and whatever other collective imaginary the government in charge may make judicious reference to, in its effort to justify its policies.

However, one should recognize the drastic change brought about by the vicissitudes of the Great Recession. As I noted in a previous analysis:

Ever since the Great Recession commenced, the three established credit rating agencies (Standard & Poors, Moody’s, Fitch) have lost the “credibility” they once enjoyed. Their excellent ratings for financial derivatives and other assets that proved to be toxic, effectively forced investors to reconsider their methods in calculating risk and in pricing assets. These agencies proved to be utterly oblivious in predicting the crisis, as their ratings suggested that the market was rather robust, when in truth the bubble was becoming increasingly unsustainable.

In addition, the effective transformation of the European Central Bank to what may be called a dealer-of-last-resort, courtesy of its Outright Market Transactions programme, has effectively rendered all such ratings irrelevant or ancillary. What prudent investors are now chiefly concerned with in purchasing sovereign debt or other assets, is political and institutional factors; hence speculation will be contained to the effectiveness of the conditionality clauses that are entailed in the OMT, or by extent to the success of the recent decisions for the completion of the Economic and Monetary Union (I recommend reading some of my latest posts on the role of monetary policy, see here, here and here, among others).

Given the aforementioned, I am of the view that tougher rules address, adequately or not, the symptoms and the concomitant effects of the problem, not the root causes. The stench of corporate capitalism (neo-mercantilism) still lingers in the corridors of power. As such, we must bear in mind that efforts which are only contained in the regulation of these agencies, rest on a misdiagnosis of the underlying presumptions of the politico-economic system that engendered the Great Recession, the Eurocrisis and all that is related to them.

On another level, the issue cuts far deeper, down to the epistemological issues of modern economics, where thinkers have not yet escaped from the fictions and byproducts of formalism and scientism. It seems to me that politicians have been willing to rectify their previous approach to the matter, whereas academics have been ever-more determined to obstinately cling on to their shibboleths.

With the insights of heterodox schools and in particular of radical subjectivists still cavalierly disregarded by the economics’ establishment, one cannot expect any kind of thoroughgoing reform of the discipline. Economics is being falsely branded along the lines of physics, and thus it may only misinterpret reality by throwing a camouflage of ostensible objectivity and of alleged truism over things and conditions that are profoundly relative and subjective. Without a change in economic reasoning, policies will be confined to sub-optimal levels, of tinkering with the superficialities of existing challenges.