COVER STORY Rating the ratings agencies: FFF and "Watch out"
by Colin Teese
News Weekly, August 13, 2016
The election had hardly moved off media centre stage than we were bombarded by the pontifications of self-styled “ratings agency” Standard & Poor’s. Actually S&P and its like are less agencies than businesses that in a competitive environment assess the creditworthiness of businesses (and more recently governments).
Competition pressures have sometimes resulted in these agencies reporting more favourably on some businesses than the facts might justify. Actually, it has emerged that, in the run-up to the global financial crisis, such actions may have intensified the impact of the crisis.
In recent weeks S&P has put Australia “on watch”. In its judgement our government is not doing enough to bring our budget back into balance; accordingly, the agency threatens, at some future time, to downgrade Australia’s AAA rating. Such a downgrade, so our government has been persuaded to believe, could result in its having to pay a higher interest rate on its borrowing.
In other words, our government has been naughty a boy and unless we do as the good ratings agency tells us we could be punished.
Sadly, our government and its opposition, along with most of business and many economic commentators, take these agencies seriously. Which is truly amazing.
The only useful purpose ratings agencies serve is to provide lending institutions and investors with accurate assessments about the creditworthiness of their customers. Over recent decades, however, they have, encouraged by certain economic ideologies, begun to make judgements about government deficits.
Before 1971 Western governments conducted their international transactions on the basis of the Bretton Woods Agreement. National currencies were fixed in relationship to each other and to the U.S. dollar; the dollar itself was tied to gold valued at $US32 an ounce.
The end of the Bretton Woods agreement meant that the West’s currencies no longer remain in any fixed relationship with each other. They are what economists call “floating”. Their values relative to each other change constantly in line with buying and selling pressures attaching to them. The floating of currencies gave ratings agencies the opportunity to opine on the creditworthiness of governments.
More about that later. Meanwhile, a plea for reader tolerance.
Readers should not be put off because this article is about finance. Contrary to popular belief there is nothing difficult about finance. All that is required to understand it is a capacity to add subtract, multiply and divide numbers. Of course, the subject is larded with opaque terminology, which is designed to hinder customers of financial institutions from understanding what is going on.
Consider the term “collateralised debt obligation”. In fact it’s quite a simple concept. Devious and deceptive, but not complicated.
When most of us buy a house we don’t have the full purchase price immediately available. We borrow from the bank what we need in addition to our savings to buy our house. The bank owns the house until the loan is paid out.
In the days when banks were more honourable, they held the loan themselves. When the last repayment was made, the bank discharged the mortgage and handed us the deed to our house. From this transaction the bank earned itself a modest fee and interest on the loan over the life of the mortgage.
However, in the last 20 years or so banks, especially in the United States, decided to get clever. Instead of holding these mortgages, they decided they could make more money by charging much higher fees to borrowers and selling off the loans to others.
The more house loans they made the more money they made for less risk. Having sold off the loans, they no longer cared whether the borrowers repaid the loans. In fact they actually promoted loans to buyers who could not pay. Their reward was the borrowing fee.
Banks behaving in this way bundled home loans together, some good, many bad, and sold them off to unsuspecting buyers all over the world: other banks, investment agencies, pension funds, for example, which believed they were buying rock-solid housing loans.
Guess what! The term “collateralised debt obligations” (CDO) was coined for the packages of loans so created.
Nothing complicated about CDOs, but they are a thoroughly unscrupulous form of business behaviour. Not strictly illegal perhaps, but deceptive, since those creating the CDOs knew that many of the loans in the packages had been made to borrowers who had no means of repaying the loans.
Many of those buying these so-called CDOs (which included some large and reputable banks) believed them to be sound mortgages. The global financial crisis was caused, in part, by CDOs. Or, at any rate, by large-scale defaults on the part of many who had been given loans that they could not repay.
After the crash, it became impossible to value the packaged mortgages; within the package were some good mortgages, many bad, and some actually valueless. Taken together it was impossible to calculate the real value of any given package.
One fact, however, was clear. In the securities market the packages represented huge losses for buyers, and these including large and famous banks all over Europe and North America. No wonder the whole episode caused an economic crisis in 2008 from which the world has still not recovered.
Irresponsible bank lending for housing in the U.S. was the fundamental cause of the crash, and ratings agencies had been involved. They were involved insofar as they rated CDOs – composed of ingredients sliced and diced beyond recognition – almost without exception as AAA.
Why, given all this, do governments take notice of such agencies? Good question. A better one might be, why did governments with their own floating currencies not recognise that they had no need to take notice of them?
Ratings agencies certainly had a legitimate role in assessing in the creditworthiness of businesses. As to governments, they might have had a role in assessments of the creditworthiness of governments of questionable honesty. Or perhaps those governments without their own currencies (such as Eurozone countries or Hong Kong.) But sound governments with their own floating currencies have no need of them.
It will be asserted that without a AAA assessment a government’s borrowing costs will be higher. There is no evidence to support this assertion. When ratings agencies downgraded Britain and the U.S., interest rates charged on those countries’ government borrowings actually went down.
Current orthodox economic wisdom insists, incorrectly, that government borrowing is a bad thing and that governments should work within a balanced budget. And it is the state of the budget deficit that ratings agencies assess.
Question to our government (and opposition): if we are not to borrow, how can ratings matter since all they affect are rates of interest on borrowing?
More seriously, we should question how much is really known about government finance by governments and those advising them. The widespread belief is that governments are like households – they must not spend more than they earn (tax collections being analogous to earnings).
Apart from being theoretically wrong, that view is actually illiterate. Citizens and businesses must earn income before they pay tax. Governments can only collect tax after earnings have been generated and tax paid on them. In other words, governments must spend money into the economy to generate economic activity to sustain business and to pay workers. Only then can tax revenue be collected.
Tax comes after spending, not before.
As to the theory, Alan Greenspan and others have made it clear. Here is what Dr Greenspan said in a speech back in 1997 when he was chairman of the U.S. Federal Reserve Bank (others similarly placed have said the same thing): “Central banks can issue currency, a non-interest-bearing claim on the government, effectively without limit …
“That all of these claims on the government are readily accepted reflects the fact that a government cannot become insolvent with respect to obligations in its own currency. A fiat money system, such as we have today, can produce such claims without limit.”
So, there it is. Dr Greenspan says of the U.S. government that there can be no such thing as credit risk. What he and others have said about the U.S. is, for the same reasons, true for Australia. We will always be AAA, regardless of what any ratings agency might say. What actually happens in the real world backs this up.
Of course Dr Greenspan was careful to explain that because governments could spend their own currency without limit did not mean that they should. Government spending should be a means of energising the economy.
If the economy is operating at less than full capacity – if capital and labour are not being fully utilised – then the only solution is for the government to inject spending into the economy.
Think about it. When the government spends it buys goods or services from business; or it employs nurses or teachers. They in their turn buy goods from businesses, which then invest more in capital and labour. When the government cuts back on spending or collects more tax the opposite happens.
Thus it becomes clear that, when the economy is not using all its capacity, the government should do what Dr Greenspan says is possible: spend. However, if the economy is overheated; that is, if there is more demand than supply, then that is the time for the government to take spending out of the economy by raising taxation.
Given what we know from Dr Greenspan and others and given the sluggish state of our economy, what do you think the government should be doing now – spending or saving?
*NB. I am grateful to Professor Bill Mitchell of Newcastle University for some of the factual information in this article. The opinions are my own.