Ratings Agencies - The Power of Modern Day Astrologers
Ratings agencies have been in the news for some time now. Governments quake in their boots whenever a ratings agency issues a press release. This article attempts to explain what a prognosis from a ratings agency actually means and it will also examine the power they enjoy in the globalised world of capital.
In the UK if a consumer wishes to buy a digital camera she would read Which? magazine in order to be able to decide which product met her requirements. In India when a parent wished to arrange a marriage for his daughter he would take the horoscope of his daughter and her prospective groom to an astrologer to check for long term compatibility. In the world of finance when an investor searches for investment opportunities she would ask a ratings agency for advice about the safety of his investment. The following table highlights the warranty offered by each service provider.
We don’t just reveal if a product or service delivers well - we also expose any shortcomings or faults it may have.
Emphasize that astrology is not scientifically proven and that no reading can be 100% accurate.
Credit ratings are opinions about credit risk.Standard & Poor’s ratings express the agency’s opinion about the ability and willingness of an issuer, such as a corporation or state or city government, to meet its financial obligations in full and on time.
The above warranty reveals that a prognosis from a ratings agency is akin to an astrological prediction and not similar to the verdict of the consumer magazine Which? Ratings agencies religiously point out that their viewpoint is an opinion and not a fact because they are aware of the limitations of the tools they use to form their prognosis. Therefore they legally position themselves as modern day astrologers whose views should be used 'for entertainment purposes only'.
Yet, why do investors treat ratings agency pronouncements as absolute truths and use them for making decisions? Free market economic theory assumes Perfect Information in an economic transaction between buyers and sellers. By this theory an investor is expected to consider each investment opportunity in great detail and he is expected to ignore the time and costs involved in researching an investment opportunity. In other words an investor should theoretically be able to quantify all the costs and returns now as well as in the future. If every investor were to use such a method only then would he be in a position to take a rational decision and maybe even discard the opinion of a ratings agency.
However in the real world an investor does not have perfect information. He has the responsibility to choose an investment vehicle quickly as time spent researching an opportunity means time lost to earn money. Herbert Simon's Bounded Rationality theory may offer a plausible explanation of his actual behaviour. Such investors, called satisficers, lack the resources to arrive at an optimal decision and apply their rationality only after the choices have been reduced.
In the book The Paradox of Choice, Barry Schwartz discusses the concept of anchoring with the example of a shop that used to sell an automatic bread maker for
$279. Later, the shop introduced a larger capacity bread maker for $ 429 and found to its surprise that the sales of its lower priced bread maker went up significantly. This was a result of anchoring, i.e. consumers who did not have any absolute judgement of value used the relative prices of bread makers as information to base their buying decision.
Similarly, the three dominant ratings agencies help to anchor an investors' decision making spectrum. Their opinions become the basis for the decision making of the satisficing foreign investor. This creates huge problems for democratically elected governments. If they choose to implement policies in their election manifesto they may fall foul of the ratings agencies and any downgrade in the country rating could start a downward spiral of foreign investor withdrawal from the markets and which eventually hurts the citizenry of the economy.
So what could be done to reduce this power of ratings agencies. In the EU, as pointed out by Ha Joon Chang government regulation prevents pension funds and insurance companies from owning assets below a certain credit rating. The Americans have however reduced the power of ratings agencies by the Frank Dodds Act, while the Europeans who complain about the ratings agencies have not yet moved to reducing their power.
Thus, when there is a proliferation of choice for the long distance investor, and when he does not have the resources to make a rational choice he will satisfice by relying on the forecasts of these modern day astrologers.
Girish Menon is a teacher of economics. He has degrees in Chemistry, Business, Economics and Information Systems. He lives in Cambridge, UK