Monday 26 September 2016

Stephen Kinsella: Ratings agencies don't deserve our trust -- so why are we getting excited?

Published 21/01/2014 | 02:30

Pedestrians walk past the Moody's Investors Service Inc. logo displayed outside of the company's headquarters in New York, U.S
Pedestrians walk past the Moody's Investors Service Inc. logo displayed outside of the company's headquarters in New York, U.S

In 1873 the philosopher Friedrich Nietzsche wrote that "knowing is nothing but working with one's favourite metaphors".

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A metaphor is a way of understanding one thing by relating it to another. When we hear Munster beating Edinburgh in rugby, and the commentator describing Munster legend Paul O'Connell as "a beast", we understand he's not saying O'Connell is an animal literally (the Edinburgh pack might disagree), but that he was ferocious. We use metaphors to understand the world. Metaphors form a self-referential net to guide our behaviour when we believe them.

The market is so complex we generally resort to metaphors to understand its workings. Sometimes the metaphor takes place within a story. One way to understand the market is as a 'village fair', where buyers haggle with sellers to get the best price. In this metaphor the prices adjust, so if sellers have too much stuff, the price comes down. If sellers have a shortage of stuff to sell, the price goes up. Another metaphor is the 'bear pit' of Wall Street, where 'the market' generally works out the right price someone should pay for an asset. If you believe either of these metaphors, then the answer to any problem is to allow the market to work the problem out.

The market is, more or less, always right. It's this metaphor driving talk of the omniscient 'markets' we hear on the radio every day. What will 'the markets' like? What will make them happy? How will we know? Well, one way to know is to rely on a trusted rating agency to do research for us.

But in 2014 we know the markets and their ratings agencies are not all-knowing. A new metaphor is needed, something to capture the reality of monopoly power intersecting with weak regulation to produce an unstable interaction which, when it goes wrong, gets cleaned up by that ultimate backstop, the taxpayer.

The economy is too complex for any human to understand. Quadrillions of dollars' worth of derivatives and financial products, trillions of transactions, billions of prices, billions of people acting as buyers and sellers, millions of firms, tens of thousands of important institutions regulating behaviour, and hundreds of governments and central banks, all trying to keep the show on the road.

Each and every one of these interactions takes place in a web of connections no one can see or understand, let alone influence. And yet there are players large enough to produce real changes within the system - at a cost. The US and Chinese governments, the European Central Bank, groups of billionaire financiers and multinational companies, all can make changes to the functioning of the system over time. Where is the metaphor for this type of behaviour?

Given this complexity, how are we to believe a single agency or government when it makes a pronouncement on the future?

Ireland has been upgraded by the ratings agency Moody's, and all the important people are terribly pleased with themselves. The reason Moody's ratings matter is simple: more corporate treasurers, particularly those in Asia, can send us their money to invest in Ireland if the ratings agencies rate us as investable. Based on this, regardless of what you believe about the markets or even the ratings agencies, the ratings upgrade is unambiguously a good thing for Ireland. But would a negative rating really have been so bad? Imagine the same serious people reacting to the news of a downgrade. What would the effect be?

The key problem I have is our poor memory when it comes to celebrating the 'good news' that Moody's finds us investable again. The academic literature on ratings agencies since the 2007 has become immense. Most of it is not complementary. Most studies point to big problems ratings agencies have: first, they have an internal conflict - it is in their own interest to understate a risk to attract business; second, corporate treasurers' abilities to purchase assets with only the most favourable ratings strangles competition; and third, some investors will only look at rating agency research before making an investment decision, meaning they rely totally on one company's opinion to form their investment strategy. Couple these problems with the finding that ratings are much more likely to be inflated during booms when investors are more trusting, and you have a big problem: you can't trust the ratings agencies.

Oh, and since the early 1970s, the rating agencies have been paid both by the issuers of securities and by the investors, doubling the likelihood of a conflict of interest. Their money, and their market, distorts other markets they come into contact with. Their opinions are just that: opinions.

In 2008, Moody's said: "The implementation of the guarantee scheme does not threaten the Aaa rating of the Irish Government."

In 2011 it cut Ireland's rating to Baa3 or junk status, citing the bailout and worries about the banking system caused in part by the bank guarantee. That should tell you all you need to about the rating agencies.

So whether they mark Ireland's debt up or not, we shouldn't play their game, or listen to their metaphor. Here's Nietzsche again: "The most accustomed metaphors, the usual ones, now pass for truths and as standards for measuring the rarer ones. The only intrinsic difference here is the difference between custom and novelty, frequency and rarity."

Irish Independent

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