Competition Will Lead to Innovation and Honesty

Standard & Poor’s sells opinions. And the opinions it sold in the years leading up to the financial crisis were — we now know — disastrously wrong: housing-related assets were not as sound as S.&P. (and its competitors, Moody’s and Fitch) said they were. The Justice Department says S.&P. was not only mistaken but dishonest and is suing it to the tune of $5 billion for civil fraud.

A tightly restricted market can result in higher prices and lower quality. So it was, and continues to be, with the ratings industry.

Perhaps Justice should be investigating the Securities and Exchange Commission. Since 1975, the S.E.C. has given only a handful of ratings agencies its seal of approval. The S.E.C. and other financial regulators rely upon that imprimatur in certain key regulations. When the requirements came on line, only three ratings firms qualified. Over the next quarter century, four more gained the S.E.C.’s approval; but by 2000, consolidations had reduced the number back down to the original three: S.&P. Moody’s, and Fitch. In 2006, Congress instructed the S.E.C. to see that more firms were included, but by then, it was too little too late.

Since the days of Adam Smith, economists have known that a tightly restricted market will often result in higher prices and lower quality. So it was—and continues to be—with the ratings industry.

The S.&P. case also underscores the point that regulations are rarely “anti-business.” More often, regulations are anti-some-business and pro-other-business. The ratings firms that obtained the S.E.C. seal of approval were better off, even if customers, competitors—and ultimately the taxpayer—were worse off.

As far back as 1973, consumer advocates Mark Green and Ralph Nader wrote that, “the verdict is nearly unanimous that economic regulation over rates, entry, mergers, and technology has been anticompetitive and wasteful.” Moreover, “our unguided regulatory system undermines competition and entrenches monopoly at the public’s expense.”

When taxes, subsidies, and regulations favor one firm or set of firms over others, it doesn’t just undermine competition. It also misallocates resources, hampers innovation, and retards economic growth. In this case, it fostered macroeconomic instability.

Had the ratings market been competitive, new entrants would have had an incentive to profit by exposing flaws in the big three’s ratings. It’s possible that new business models might even have emerged. For example, perhaps more raters would have marketed their products to investors interested in buying securities rather than to the firms issuing the securities, sidestepping conflict of interest concerns. (The investor-pays model was the norm from the 1930s to the 1970s). 

Elimination of privileges elsewhere in the financial system would have helped too. In the years before the crisis, for example, mortgage giants Fannie Mae and Freddie Mac enjoyed the implicit (and then explicit) backing of the Federal government, as well as an exclusive line of credit with the Treasury, an exemption from state and local taxation, an exemption from S.E.C. filing requirements, and lower capital requirements. These and other privileges systematically encouraged labor and capital to flow into an over-heated housing market. 

Privileges granted by the government tend to favor the wealthy and well-connected at the expense of the relatively poor and unknown. Ultimately, as the federal lawsuit against S.&P. demonstrates, they undermine the legitimacy of both government and free markets.