The continuing brouhaha over Standard & Poor's downgrade of the United States government's credit rating offers a powerful lesson in institutional economics.

In standard economic models of "efficient markets," we can all easily obtain the accurate information we need to make good decisions. In the real world, we often cannot, in part because so much mis- and disinformation competes for our attention.

 

Many economic actors have an incentive to lie and cheat, and it is often hard to figure which ones actually do. Markets work best in an institutional environment that creates strong incentives for everyone to tell the truth.

 

Whether you call this institutional environment law and order or, more specifically, regulation, it's not easy to design because it is so easily corrupted. Those who anticipate the largest potential gains or losses typically dominate the decision-making process.

 

Some observers, as well as some representatives of the Obama administration, view the Standard & Poor's downgrade as a strategic effort to retaliate against regulatory changes that would adversely affect the company as well as a political intervention in the deficit-reduction debate.

 

Their fury was intensified when John Bellows, acting assistant Treasury secretary for economic policy, discovered a significant informational error (a miscalculation amounting to $2 trillion) in Standard & Poor's initial explanation of the rating change. The rating agency declined to change its assessment after the error was pointed out.

 

Most Republicans interpreted the rating change as support for their insistence on deeper budget cuts, although some were perhaps chastened by Standard & Poor's emphasis on a crisis of governance induced by resistance to compromise.

Yet there is widespread bipartisan agreement that our dependence on the current credit ratings system is dysfunctional.

 

Ratings provide a far simpler and more comparable measure of creditworthiness than an in-depth analysis of every company's balance sheet can offer. Reports from Standard & Poor's, Moody's and Fitch, the three most prominent agencies recognized as nationally recognized statistical rating organizations help guide both individual and institutional investment decisions.

 

But the ratings that these companies provide are often incredibly misleading. Their epic disregard of mortgage-backed derivative scams contributed to the near-collapse of the financial sector in 2008.

 

In general, ratings tend to follow the market rather than to inform it and may even worsen information problems, by giving investors a false sense of security. Rating companies argue that they can't be held legally liable for mistakes, because this would infringe on their free speech (an argument that will eventually be tested in court).

 

These failures are clearly linked to a basic flaw in institutional design: credit agencies receive payment from the very companies they rate, not the potential buyers who seek information about those companies.

 

Imagine baseball umpires who could be hired and fired by one team, movie reviewers paid entirely by Hollywood or restaurant critics who depend on the chefs they evaluate for every meal. All these arrangements violate a basic economic principle that incentives should be aligned to encourage rather than discourage honesty.

 

Conservatives sometimes play down this issue, emphasizing instead that government regulation has squelched competition by requiring many institutions to meet targets for portfolio composition based on ratings by the top three firms.

 

But these two problems are not mutually exclusive. The links between them have long been emphasized by scholars like Frank Partnoy, who published a detailed law review article on the topic in 1999.

 

It's not regulation per se that causes the problem, but bad regulation that could, in principle, be fixed. Thanks in part to the efforts of Senator Al Franken, Democrat of Minnesota, the Dodd-Frank Wall Street Reform and Consumer Protection Act outlines a number of specific policies that would diminish the influence of the top three rating firms.

 

These policies won't solve the misinformation problem, but they could substantially reduce it. (For a more detailed analysis of this issue, see this working paper by my University of Massachusetts colleagues Gerald Epstein and Robert Pollin.)

 

Of course, these policies will also reduce the profitability of the rating agencies. And implementation of Dodd-Frank as a whole faces enormous resistance, manifest in Congressional maneuvers to starve the Securities and Exchange Commission of money necessary for its effective enforcement.

 

The credit rating war is likely to escalate. Large institutional investors and hedge funds, with their hefty research departments, will be able to rise above the fray. Small investors trying to garner the information they need to make intelligent investments in stocks and bonds will continue to suffer casualties.

 

As for ordinary workers – they are just part of the supply chain. The business community has already lowered their rating far below investment grade. NYT.15.08.

 

Nancy Folbre is an economics professor at the University of Massachusetts Amherst. 

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