If the market is god, ratings agencies are its high priests.
For a while it seemed as though rating agencies had fallen from this grace. The US Financial Crisis Inquiry Commission called them “key enablers” of the financial crisis and “cogs in the wheel of financial destruction.” If it weren’t for lack of funding, European leaders such as Jean-Claude Juncker would have replaced them with an institutional equivalent.
Most criticism concerns how the agencies did their business: the fact that they were part of a collusive oligopoly and corrupt insofar as they were funded by the very companies they were meant to be rating. New EU legislation aiming to make ratings less frequent, more transparent, and agencies culpable for their judgments concerns itself with, and only with, these flaws. But these changes will not allow agencies to foresee the next crisis, nor to rate more intelligently in the future if the economic system to which they subscribe is not better at doing so. The rating agencies’ key flaw is an intellectual one: they share – and must inevitably share – the same set of economic dogma as those they regulate. It is the kind of corruption that occurs when everybody thinks the same way.
In order to understand how rating agencies could get it so wrong, we need to look beyond the failures of single institutions and at the political economy at large. The 90s and 2000s are the story of a Republic where Philosopher-Kings like Francis Fukuyama proclaimed that “history had ended” and their main man, Alan Greenspan, saw the ever more unfathomable complexities of financial products “as signs of a flexible, efficient, and resilient financial system.”
Before 2008, it was common sense that the mathematical models used by the financial sector to create, rate, and secure financial products were perfect, that the system was basically incapable of failing and that real bubbles were a thing of the past. This allowed the total amount of capital that was in unregulated Credit Default Swaps (to just mention one financial product) to exceed that of the Global GDP.
Living in a Bubble
In hindsight we know better and feel that ratings agencies should have been held to a higher standard. There is outrage that Moody’s, for example, put its triple-A stamp of approval on 30 mortgage-backed securities (MBSes) every working day when in reality they were basically worthless. But from where was this “higher standard” or different approach to come? Other forms of “less perfect” economics such as industrial Keynesian economics had even been banished from most economics faculties. There was no infrastructure of ideas to fall back on when “perfect” economics failed. The second problem of this outrage is a definitional one: its notion of “reality” is unclear. MBSes are securities, not pencils.
Financial capitalism is inherently removed from the creation of real wealth. The value of its products is the value that the market dictates. The high prices of the early 2000s therefore reflect the real as well as the perceived value of these securities. When the bubble burst in 2008, the real value of these securities fell drastically and Moody’s downgraded 83% of triple-A rated mortgage related securities that year. AAA is of course a laughable figure for anything but US government bonds, but this gross exaggeration is a matter of grade inflation (which also happens in conservative schools). Anyone that believes there is a solution as simple as a choice between a “loose” and a “conservative” way of doing the rating agency business should note that grade inflation has reappeared.
In a financial word of massive uncertainty, complexity and the constant threat of destructive shocks, ratings agencies have the assigned function of what Jacques Lacan would call “The Other that Knows.” Unfortunately recent history has proven us wrong; they do not.