UPDATE: With ratings agencies back in the news, I’m re-posting this one. This week Standard and Poors have essentially punished the US for the fiasco over the deficit. We will find out on monday how much that will cost the country, and the rest of us. But who are S+P, and why do they get to decide anything at all? …
Who sets economic policy for Britain? The Chancellor? The Bank of England or the Business Secretary? Or is it someone else entirely?
Britain has a AAA credit rating. It means we’re a safe bet as a country, that buying slices of national debt is a sound investment. People are willing to lend to us, and our interest payments are low. Just as well, since we need to borrow £146 billion this year.
But ratings change. AAA is a privileged position, but it can slip to AA+, AA, AA-, and then, heaven forbid, just the one A. Anything below the As and people will start to wonder. You’re on a slippery slope towards being a junk bond, and good luck raising finance then.
As Greece and Portugal and others have found, once the credit rating begins to slide the cost of borrowing suddenly soars. Increasingly large tranches of the budget go towards paying off interest, leaving less for investing or stimulating the economy. The economy slows, the rating falls again, and it turns into a vicious cycle. The only response is to slash government services and keep up the payments at all cost, trying to reassure your creditors. So it’s important to steward that triple A rating.
The important question then, is who decides how to rate a country’s debt? The credit ratings agencies of course – Fitch, Moody’s, Standard and Poor. Those three companies are responsible for deciding who is exercising financial restraint and who isn’t, who is worth investing in and who’s a dodgy prospect. And they know what they like – low government spending, and robust growth.
They’ve been analysing the budget this week of course, scrutinising every policy. They didn’t like what George Osborne had to say: “Although the weaker economic growth prospects in 2011 and 2012 do not directly cast doubt on the UK’s sovereign rating level,” wagged the finger of Moody’s, “we believe slower growth combined with weaker than expected fiscal consolidation could cause the UK’s debt metrics to deteriorate to a point inconsistent with an AAA rating.”
Naughty Britain, not growing fast enough, not cutting services fast enough.
And they don’t just comment after the budget is delivered. They say what they’d like to see ahead of time, to give the Chancellor time to factor in their wishes. A fortnight before last year’s emergency budget, when the coalition was fresh out of the box, Fitch made it very clear what they wanted to see – detailed policies for deficit reduction. “Much, much more needs to be done” said Standard and Poor’s.
They even meddled in the election. Fitch warned that whichever party won the election would need to make a large “budget adjustment”, or the credit rating could not be guaranteed. Despite this being a veiled form of blackmail over the electorate, George Osborne, then Shadow Chancellor, declared that “we all need to sit up and listen to this warning.”
And that’s something he’s done every step of the way. “The thing I’m aiming for is making sure that Britain keeps its credit rating” he said ahead of announcing the budget cuts. “The bulk of dealing with the deficit has to come from spending restraint.” He began this week’s speech by boasting that while other countries had seen their ratings downgraded, Britain’s was still sound. Forget the rising unemployment, inflation, and the falling standard of living – the credit rating is okay!
Of course, the biggest problem here is the debt. If we didn’t owe so much in the first place, we wouldn’t have to worry about interest rates. But the credit ratings agencies still have too much power. They are essentially able to dictate a small-government, pro-business agenda, or punish the economy with a downgrade. And we pay them for the privilege – ratings are commissioned by the issuer of the debt, not the investors.
This, if you think about it, is a stupid way to do things. If the issuer pays for the rating, it’s in the interests of the agency to overstate. As Joseph Stiglitz points out, it gives them “an incentive to please those who were paying them”. Companies and governments looking to get rated are going to go with the company that gives them the highest score, and over-inflated assessments of credit-worthiness have a lot to answer for. The financial crisis, if you remember, was triggered in large part by incorrectly rated derivatives. The issuers of the mortgage debt paid the credit ratings companies, they blessed the investment vehicles with AAA ratings, and off they went into the markets like time bombs.
It’s time we put an end to the monopoly of the credit ratings agencies. They are unaccountable, irresponsible, and compromised by perverse incentives. They have done untold damage to economies across the world, and to millions of people affected by government cuts.
Action against them has to be international, and both the UN and the EU have investigated. Lydia Prieg at nef has more on how the system could be reformed. Reform can’t come soon enough.
The Earthbound Report 
Anyone can if they want set them self up as a ratings agency. Recently the Chinese have set up a ratings agency, Dagong, to be their version of S&P. A ratings agency, like a blog has to find a paying audience for their reports of course.
At one level these ratings agencies have power, which some might say they misused and helped cause the current crisis. But at another level these agencies are to some extent just stating the obvious, they downgraded Greece and Portugal long after the market had priced their debt at a lower level. You can insure your debt against default and the price of this insurance is a good estimate of actual rating of the bond. The rating agencies lower or raise their ratings in response to changes in the cost of the insurance. Complaining about rating agencies is at one level complaining about the messenger.
As an aside, I cannot see in a sane word how the US can possibly default, as they can always just print more of their currency to avoid default. There are only a handful of countries which have the luxury of borrowing in their own currency, the UK being one of them. If we lose our AAA credit rating we could lose that privilege and that would be very costly. A US default would therefore be a political choice, one which the agency thinks after observing the recent farce in the US over the debt ceiling they think is a little more likely.
Yes, they are in some ways the messengers, but the problem is that they’re also seen as guardian of a sort, keeping an eye on risk and informing the markets. They have failed in that task in every way, pricing up risky investments as triple A and failing to spot troubled assets in time.
Some of the ratings system may be based on the cost of insurance, but it works the other way too: an insurance company can use credit ratings to decide how to price insurance. That was the problem with derivatives during the financial crisis, where mortgage pools were sliced, bad loans mixed with good ones and rated far too highly, then speculated on through credit default swaps. That’s what brought down the insurer AIG.
PS – yes, I agree with you that if the US defaults, it’s far more likely to be a political choice rather than an economic necessity.
The cost of insurance is related to price of the countries bonds, if the market thinks there is only a 50% probabiliy Greece will pay it’s debts the bonds will be priced at 50% of their nominal.
Countries are in some ways no different from individuals, if you want a loan from your bank you have to do what it tells you. If you don’t like this then we need to stop borrowing anymore money, then we can ignore whatever the ratings agencies tell us.