The Trouble With Ratings Agencies

In considering what can be done to improve the global economy, today I would like to add my opinion to those who think that these ratings agencies, the best-known three are Moody's, Standard & Poor and, Fitch, have entirely too much power.

A rating agency can downgrade a country or a corporation, and risk sending the economy into a tailspin. I referred to this in the posting on the economics blog, "Economic Collapse" that I wrote in the autumn of 2008. These agencies operate on the same principle as the four that rate the credit scores of individuals in the U.S.

The trouble with these ratings is that they tend to be self-fulfilling. The effect is similar to that of continuously announcing that there is going to be a recession. Such warnings cause more people to be cautious about spending and hiring, and this in itself is what brings about the recession.

When a country is struggling economically, and gets it's credit rating lowered by one of these agencies, investors will tend to abandon the country's bonds. It's borrowing costs will rise, causing it to struggle even more and thus perpetuating the cycle of self-fulfillment.

The same effect of self-fulfillment can be seen with individual credit scores in the U.S. When someone's score is raised, it enables him to get loans easier and with lower interest rates and improves employment prospects, all of which tend to make the score rise even more. But when someone's score is lowered, it makes loans more expensive and lowers employment prospects, which invite further lowering of the score.

Due to this self-fulfillment effect, these ratings agencies cause the economy to be more volatile than it would otherwise be. An announcement of either a rise or a drop in the score invites further movement in that direction. Those with upgrades look better than they really are, and those with downgrades look worse than they really are. The effect can be compared with that of global warming, the wet will be wetter still and the dry will be dryer still. The ratings of companies like AIG were a significant factor in the economic meltdown of 2008.

Like any human organization, we can be sure that these ratings agencies are less than perfect. All of this is a part of our dependence on credit. Investors seem to treat reports from these agencies like the word of God. The resulting upward and downward spirals of self-fulfillment are among the spirals that I described in the posting "The Healthy Economy" on this blog.

By the way, I am not writing this posting just because Standard & Poor recently downgraded the United States for the first time in it's history. I wrote out this posting before that happened.