Thursday, March 13, 2008

That'll Show 'Em

Ezra Klein on the FAA's fine of Southwest for being a bit too lax on their safety inspections:
This is why we need government in certain industries. The Libertarian solution here -- that a plane would crash and the market would punish the irresponsible -- would be sort of shitty for all involved.

As someone who used to fly ValuJet, allow me to concur full-throatedly.

4 comments:

Daniel Merritt said...

I'm not sure that would be the whole Libertarian solution. I think a Libertarian would say that customers would know the company was skimping on safety inspections, and push prices down. People could then choose if they were willing to accept higher risks & lower safety standards in return for lower prices.

I think that solution is also unworkable, since that information is neither easily available nor do consumers have time to look up facts about every single facet of every single company they use. I think it's less ridiculous than "well, a plane will crash, and then we'll know" though.

You could go a step further and say consumers would then form an organization to do these inspections for them, and pressure airlines to get certification from that organization. But this falls down since consumers (AKA voters) have, in fact, done so: they just called it the FAA and it's run by the government.

PG said...

And as demonstrated with the credit rating agencies' laxness of standards helping to lead to the current credit crisis, when there are certifying private sector organizations, they're even more liable to capture by the entities they're supposed to certify than are governmental agencies, because the free-rider problem of their provision of certifying information means that their business model can't rely on consumers' paying them. At least in government, the administration that allows a major failure in regulation to occur is dependent on the good will of voters/ consumers and faces electoral repercussions -- there are none for the credit rating agencies that were paid by the very corporations and brokerage firms whose securities they were supposed to be rating.

Anonymous said...

I think Daniel Merritt is right that part of the libertarian answer would be some sort of private certification system, but I disagree with pg that free riding dooms private systems to failure.

The recent failures of the private credit certifying system does not necessarily demonstrate that it is less reliable than a government certification system would have been. All information/certification systems fail periodically, and in the case of the credit crisis I don't think it is clear that some sort of governmental regulatory system would have done any better.

The more instructive comparison would probably be how quickly and effectively the public or private certifying institution respond and improves their policies once their deficiencies are exposed.

My guess is that a private certification system would respond more effectively than a governmental system if the private system's customers really care about the quality of the certification service (as opposed to just buying a certification window dressing).

I would be interested to see evidence one way or the other.

PG said...

anonymous,

I think you misunderstand my point about the credit rating agencies. From what I understand, originally they attempted to make money by selling the information directly to consumers, e.g. through issuing reports to securities buyers. This created a free-rider problem because such reports were easily passed along, which meant not enough people were buying them to subsidize the work of analyzing financial statements, etc. to produce the ratings.

Therefore the agencies changed their business model; today, the credit rating agencies get the majority of their revenues from structured finance. They're now caught in a a couple different binds that make them reluctant to give their most brutally honest assessment of securities.

1) The more altruistic one: Because of debt structuring, any downgrade in rating can cause a collapse, which was part of what happened at Bear Stearns recently. If Moody's drops its rating of Bear from AAA to Baa, that automatically calls in Bear's debts and if it's not liquid enough to pay those debts, off to the bankruptcy court -- or a bailout.

2) The more self-interested one:
Structured finance is different; it involves i-bankers putting together these pools. Instead of the one-shot transactions for IBM, these were i-bankers coming to the agency once a week, now a major client. By 2000, structured finance became the bulk of credit rating agencies, and there were a limited number of i-banks who were repeat customers. They would get advice on how to get just over the investment grade line.
The economics of all this are that the credit rating agency gets all its money at the front end by the issuer/originator, a fee for rating on the date that bonds are sold. The credit rating agency is expected to keep its ratings current, but it doesn't get paid to do so, especially for downgrading. The CRAs became tardy in updating, because they didn't get paid and were making both the originators and the mutual fund investors unhappy when they downgraded. Downgrading only happens when it's inevitable, right before default.

Moody's downgraded bonds on about $8 billion of securities. This caused the financial failure of several large hedge funds, esp. Bear Stearns, but these were delinquent downgradings. We want the credit rating agency to give a prophecy, but the downgrading is an obituary – not forwarding looking, but backward looking.

If you're interested in the role of credit rating agencies, I strongly recommend Jack Coffee's work, particularly his book on Gatekeepers.

Finally, I'm not calling for the government to do the work of the credit rating agencies. The comptroller of the currency tried that briefly and it didn't work. Rather, I'm saying that the credit rating agencies themselves need to be regulated more closely. They're pretty much immune from suit because the 2nd Circuit has said that their ratings are First Amendment protected statements of opinion.