Legal Commentary

What Would Public Choice Theory Say About Rating Agencies and Sovereign Debt?

By Kenneth Anderson

Particularly since the European sovereign debt crisis put the question of sovereign debt ratings squarely on the table, and even more in the last few days since the rating agencies have downgraded Greek debt to junk status, I have to wonder what insulates Moody?s, Standard & Poors, and Fitch against pressures direct and indirect, subtle and not so subtle, by interested sovereigns.  The New York Times business pages ran a story on Friday (January 14, 2011, Graham Bowley) reporting that Moody?s and the S&P warned the United States that its outlook might conceivably put its AAA status at risk.  In Europe, it?s not just Greek bonds that are finally in question, it?s the debt of much bigger states as well ? and the fact that the rating of sovereign debt even of Greece matters quite a lot to Germany or France for many reasons, not the least of which is that so much of it is held by their banks.

Standard public choice theory seeks to account for the essentially political forces that ?supply? law and regulation to its economic ?consumers? (voluntary or not!) in the marketplace.  It fills in a crucial gap in the account of law and economics, which tends to start with the laws and regulations and their creation as a given for structuring the incentives and disincentives of markets.  It connects law and markets, politics and markets, politicians and market-makers.  Sovereign debt, for its part, is a commodity in the markets that depends in very special ways on political and governmental forces, in part acting as market players, but in part acting as rule-creating sovereigns.  All of which is a roundabout way of saying that sovereign issuers of sovereign debt have large incentives to use their rule-influencing, regulatory, and law-creating powers, their political will, to influence market outcomes.  Rating agencies, one would have thought, would be particularly susceptible.

The model of rating agencies is built around private actors assessing other private actors.  Regulators act to ensure that the agencies not fraudulently sell their ratings for other private actors.  But we all know the ways in which that model departs from the ideal, starting with who pays for the rating, and all the other ways in which rating agencies failed to deliver objective, reliable assessments.  Government, in seeking to reform financial regulation, has many reasons to investigate, reform the rules, and perhaps hold agencies accountable for departures from the rules in the past.  But that, of course, presents many opportunities for governments to pressure rating agency behavior down the road, with respect to a given government?s sovereign debt.

That?s just one example; one could look to others.  US regulations still mandate in various ways that ratings from the established agencies be used for many purposes; a lively debate has ensued over whether those requirements are prudent, whether they cartelize the agencies and reduce competition or ? as David Skeel notes in his new book, The New Financial Deal ? can create competition among rating agencies leading to a ?race to the bottom.?  Those regulations provide both a great deal of automatic business to the rating agencies and protection against competition.  They are therefore a potential source of pressure on the rating agencies for other purposes of sovereign borrowers.

Curiously, I have not so far seen evidence that leading sovereigns are putting political pressure on the rating agencies.  (If I have missed something about this, please advise in the comments; I?m interested in the US as well as other leading sovereigns in Europe and elsewhere.)  Standard public choice theory would say, however, that especially in an economic activity so crucial to the state, and where the private actor is already part of regulatory structures for other reasons, the internal wall that separate sovereign politics from the sovereign as mere market actor has to come under pressure, at least as the political pressures rise.  And surely the political pressures are rising.

Is that happening now and I have missed something?  If not now, why not?  Why would this not happen as standard incentives theory would predict?  What form is it likely to take in the future?  Does it matter?

(PS.  Steve Schwarcz has written extensively about rating agencies; see his faculty bibliography page for various articles.  I would also be curious as to what my colleague Anna Gelpern and her occasional co-author Mitu Gulati, both leading academic experts on sovereign debt, would say ? is this an issue in the larger world of sovereign debt?)

Full post as published by The Volokh Conspiracy on January 15, 2011 (boomark / email).