An interesting post by Matthew Yglesia (via Jim):
...Toaster makers would hire toaster-inspectors, and ask them to give the toasters a clean bill of health. “That’s crazy,” you might say, “who would trust a toaster-rater who was getting paid by the toaster-makers?” But the answer is clear. A toaster-rating agency needs to have a strong, credible brand to be valuable to toaster-makers...
...Now as it happens, we don’t handle consumer product safety like that. But we do handle bond rating that way. But there are only three ratings agencies. And as it happens, during the late boom years all three acted corruptly. So instead of losing credibility and going out of business, all three are still in business. And when you think about it, something similar happened with the big accounting firms during the Enron bust...
... the market approach seems to have totally failed. Not just failed once in that the ratings-agencies screwed up. But failed in a fundamental way—the agencies’ screwups aren’t doing them any harm, and aren’t allowing any new firms to enter into that space. I don’t know the territory well enough to know in detail what’s gone wrong, but it’s obvious that something’s gone wrong.
Firstly, I'm not sure what he's getting at regarding the Enron bust - Arthur Anderson went bankrupt. Although I don't know the territory especially well either, I'd like to draw upon some exposure I've had to the industry. I wrote a report for the Financial Reporting Council in July 2006(.pdf) where I argued that the auditing industry was competitive, but one of the methods proposed to increase competitiveness was: "pursue measures to get company information into the public realm".
People who claim that "the market has failed" should immediately asks themselves two key questions:
- How much of a genuine market is this? To what extent do the regulatory constraints that pervade all markets affect the outcome? What are the hidden interventions?
- Am I committing the Nirvana fallacy? Am I comparing the real world to a hypothetical utopia, or am I comparing feasible alternatives?
A classroom experiment I like to utilise is to take a few cans of Coke and shake one of them rigorously. Then mix them up and ask a student to open one. Before they do so, I ask the class what they should do in a situation like this. Most get the objective - don't open *any* of the cans. This isn't a perfect solution, since the opportunity cost is a potential can of coke. Hence as George Akerloff points out in Section 4 of his seminal paper, we would expect institutions to emerge to validate the assets. But the point of comparison is important. We shouldn't assume a world of symmetric information and then bemoan "the market" for any divergence. The status quo is asymmetric information and market institutions provide more coordination that would otherwise be the case. The comparative institutional approach is in conflict with standard neoclassical theory, but is hardly heterodox.
But how *do* markets harmonise information? Through trading. But it is illegal for people with access to the most useful information to allow the market price to reflect it. Insider trading is the "market" response to the problem, and radically mitigates the asymmetric information problem. Ratings agencies are just one possible "market" solution to the asymmetric information problem, but another is to permit people who disagree with the ratings agencies to trade on that knowledge. This is where a knowledge of Public Choice theory is important, since there is a difference between mercantilism and free trade; between corporatism and entrepreneurship. If you have identified a cosy cartel, this is likely to be a response of barriers to entry rather than costs of entry. If you think the ratings agencies are ineffective, try living without them. If you think an alternative might be *more* affective, at least recognise that the status quo is not a free market. There are sound arguments against insider trading, but at least permit its place at the table. Markets will never deliver a perfect world, but the question should be: compared to what?
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