An Economist, Physicist and Chemist are stranded on a desert island. They have abundant food but no means of starting a fire.

The Physicist says: "By applying some fairly fundamental principles of thermodynamics I'm confident we can solve this"

The Chemist says: "I'll have a hunt around, see if I can whip up the basics for a chemical reaction that'll provide us with heat."

The Economist says: "Let's just assume we have some matches"

…It's a weak gag that unfortunately says so much about Economic modelling.

It is only to give the appearance of separation of power which should elicit a feeling of third party opinion in the market place.

However, just like the Central Bank is neither independent nor is it objective, the rating agencies take their marching orders from the entities that pay for their opinions; ergo the banks.

Well if the ratings agencies also have a shoddy record on sovereign risk that brings me back to my initial unease – why do we bother with anything they say?

Thanks for the link, haven't checked it yet.

And I seem to recall an article I read somewhere that ratings agencies have a poor record with developing countries. They are often much more credit worthy than they are given credit for. Can't find the link now.

@ Ben

Nice question to Jane. Implicit in all their models is that the system is unsinkable. Tell that to the Titanic passengers.

Re: the Titanic, interesting to note that accounts report that even when informed the ship was sinking many passengers continued to drink in the bar refusing to entertain the unthinkable. Sound familiar?

A distant aquaintance of mine – lets call her Jane – works in a large financial institution in London.

We had an interesting chat about her work, which as I understand it, includes directing a large team of mathematicians to model the risks associated with the artificial structured products she is creating.

(That is, structured products made from pools of other structured products in the way that MBS were made from pools of mortgages.)

I gently offered some of the worries we have about that sort of thing.

She explained that what they did was figure out a statistically rigorous model of the potential risks for each tranche of the product in various scenarios – both pessimistic as well as good ones.

And then they hedge that risk – insurance if you like, with a counterparty who will pay out if the product goes bad.

So, she explained with a flourish – there's no risk any more at all because it has been insured & the risk is covered.

I thought about this for a moment. I had a final question.

'So,' I asked, 'how do you put into your model the risk of the entire hedging system breaking down and not paying out?'

There was a long, thoughtful pause.

'Ah.' she said. 'Well, no, that's not built into the models. You do have to assume the system doesn't suddenly stop working.'

"relatively accurate sovereign ratings"

Unfortunately, the ratings agencies have never had a good record on sovereign default risk either. I recall in Reinhert & Rogoff's "This time is different" that rating agency default risk assessment was one of the worst predictors of collapse.

I suspect that they are in fact just tools for the economic hitmen to wield around.

This is article contains the first half or so of the book. Quite powerful stuff, especially given it is coming from within the establishment:

http://www.economics.harvard.edu/files/faculty/51_This_Time_Is_Different.pdf

thanks, that helps clear some o' the confusion. So sort of another private-public divide between commercial and sovereign ratings. Commercial ratings based on less than transparent private-sector data are the agencies' bread and butter while the public availability and reliability of national data makes for relatively accurate sovereign ratings(unless we are talking USA, UK, Japan, Germany, etc.)

Wildebeasts is indeed a better analogy (I knew I was being too kind writing 'worker bees'!), though I am still fascinated by the relationship between wildebeasts, amongst others, and the collective herd or ecosystem as a whole. Nobody admits membership of 'the markets', Goldman sachs speak of the markets as though it were otherly and yet as far as I am concerned they are lifetime members.

Thanks again David, you are performing a wonderful public service 🙂