The non market force behind rating agencies

Is S&P a Weapon of Mass Destruction ?

By Anthony de Jasay

Is Standard & Poor, the venerable debt rating agency, a weapon of mass destruction reminiscent of the pre-Iraq war of George W. Bush and, like that phantom WMD, perhaps a merely imagined one? The answer is not easy to call, and has some relevance to how we should evaluate the strident demands for more and more regulation to correct alleged market failures.

After some early warnings, early in the new year of 2012 Standard & Poor, in a massive artillery barrage, downgraded the debt rating of 9 of the 17 member states of the Eurozone, some of them by as many as two notches. It did so on a Friday evening, and the majority of the media promised a bloodbath in the bond and stock markets for the following Monday. There was no bloodbath. If anything, markets were firmer. Manifestly, a downgrade by one of the two dominant rating agencies is either a non-event—which sounds very unlikely,—or the nasty, wicked "speculators" have fully anticipated the downgrade and priced it into the markets well before it has actually taken place.

The spectacular mass reduction in the estimated creditworthiness of the majority of Eurozone countries has set off a storm of furious indignation and cranky proposals. Some of these were laughable, some dangerous. It was said that private debt could well be rated by private agencies, but public debt must be assessed by a public body—needless to say, a democratic one. An earlier proposal by the Brussels bureaucracy that the EU should establish its own rating agency to "break the monopoly" of the private ones, was also revived. Many voices from the Continent of Europe trotted out the truly lunatic conspiracy theory that the rating agencies, being undeniably "Anglo-Saxon", are promoting the interests of the USA and Britain who want to break the euro which, if it survives, would threaten the "ultra-liberal" domination of the dollar.

Defenders of the agencies say that blaming them for the bad news they spread is to blame the thermometer for showing the patient's fever. This, however, is to draw a false analogy; for what the agencies announce is not a fact, such as the temperature, but their estimate of the probability that the patient will die prematurely, i.e. that the debtor state will default on interest or principal at or before the due date. Seen in this light, downgrading is not malevolent or outrageous, but logically correct. Only four countries in the Eurozone—Germany, Finland, Luxemburg and the Netherlands—are judged by S&P to merit the top AAA grade, and even that may be a shade too generous, for the probability of default is strictly speaking never zero. AA is about as good as any long-term state obligation may possibly deserve. Where S&P is clearly blameworthy is the timing of the mass downgrade. In year after year of ominous overspending, the notes of most of the euro-states were left peaceably unaltered, only to be brutally cut just when all these states seem to be more or less convincingly scrambling to change their ways and reduce their unsustainable budget deficits. Why downgrade them now when it was not appropriate to do so while they were still spending as if there were no tomorrow and piling up the debt was only for petty, mean-spirited accountants to worry about.

A classic fairness rule holds that you must never kick a man when he is down. An eminent historian of ideas, John Plamenatz, once said in my hearing that this rule was typical of the silly English, for the man being down was obviously the most convenient time for kicking him. S&P must implicitly believe that this was so.

One downgrade that really looks shockingly timed is the lowering of Italy by two notches to BBB. Italy, in the last years of the shaming monkey-circus that was the Berlusconi era, (as the unforgettable Lena Horn used to sing) was "lying face down in the gutter" and seems not even to mind it too much. During these inglorious years, its rating remained intact. When late in 2011 it became obvious that Italy's national debt of 1.7 trillion was too much for her national income of 1.5 to carry, the incorrigible Berlusconi was forced to resign and was replaced by severely serious Mario Monti who, with admirable courage that only a non-elected statesman can afford, produced an admirable programme of structural reforms they fully deserve the hate-word "ultra-liberal", though the author and the habitual readers of this column would be more comfortable with calling it simply "liberal" on the original freedom-of-contract sense of the word. If Mario Monti can defeat organised labour and the vested interests of business and the professions, Italy should have a brilliant future over the next few decades. It seems monstrous, then, that S&P are kicking Italy, not when she is still lying face down in the gutter, but when it is bravely scrambling to get back on its feet.

Does such infamy help to make the case for the bizarre Brussels proposal to regulate the rating agencies to have some public control over what they may or may not say about the creditworthiness of sovereign states? Such regulation would be a good way for ensuring that nobody paid any attention any more to what they did say .

If a rating downgrade lastingly depresses the price of sovereign debt, then it is a self-fulfilling prophecy, for it makes the refinancing its maturing chunks of the debt more expensive, hence the budget deficit larger than it would have been if the rating agency had kept quiet. It is, therefore, a WMD. Since, however, rating agencies will almost necessarily be created in a free market, and their self-fulfilling prophecy spoils the natural scheme of things and makes for market failure, such agencies ought to be outlawed or severely regulated. This, in a nutshell, is the view if much of the Brussels bureaucracy and of semi-educated European commentators. It is becoming parrot-talk.

Remember, however, that the rating is not fact-finding, but a forecast. It is a judgment inspired by facts, like any other forecast. There are literally hundreds of such forecasts flooding the public forum every month, poured out by the OECD, the IMF, the ECB, the Brussels Commission, government agencies, universities, non-profit research organisations and private consultants. Many of them employ more economic brainpower than S&P or Moody. The institutional investors who make the bond markets routinely take some notice of the forthcoming forecasts. The cleverest among them may even anticipate the rating agencies, selling bonds prior to a downgrade and buying them back after it. But no market participant has good cause to believe that the agencies are any more prescient than the other forecasters. Why, then, do we assume that they are more powerful than the average of the others?

Much of the answer lies in one word: they have an ally. It is a non-market one, not a spontaneous growth but a political and institutional artifact: a legal rule, or self-regulation adopted to forestall it. Governments, believing that they are doing good, forbid certain types of investors, notably pension funds and insurance companies, to buy and hold debt securities that the agencies do not rate highly enough. Even non-regulated funds will conform to such rules because the fund manager may be more interested in looking prudent and blameless in case of accidents than in maximising the return to the fund's owners. Such principal-agent conflicts may be the secondary effects of government regulation.

Once a country's sovereign debt comes to be graded below the critical level set by regulation, or even threatens to be set below it, the regulated funds must liquidate their holdings as an automatic knee-jerk reaction. The market, in other words, is artificially programmed as a safety-first mechanism and not, as a flawless market is supposed to act, mechanism for balancing risk against reward, as risk and reward are perceived from day to day by the marginal buyers and sellers who are trying to do the best they can and are under no constraint to jump when the rating agencies say "jump". The ones who jump mostly do so, not because they fear the agencies as weapons of mass destruction, but because the regulators say so and public opinion discourages contrarian judgment.