Free-market anarchists believe [0] that we can do without government. For example, private rating agencies will spring up to provide a "seal of approval" that currently regulation provides: the Food and Drug Administration will be replaced by some private safety standard company
specializing in rating drugs, car safety will be ensured by a private corporation that tests cars, etc. By having a seal of approval a company can charge a premium, and rating agencies will be kept honest as they make their bread and butter off their reputation as honest and accurate providers of quality. At the same time the costs of regulation are removed, and consumers are given a choice - they can judge for themselves if they want the unrated product, or the more costly product with a seal of quality on it. Win-win.
But is this likely? The accounting firm debacle (remember Arthur Anderson?), followed by the more recent credit rating agency failure, suggests that it is not. One can claim that small number of players is the cause, and that imperfect competition is the problem - we just need more rating agencies to compete, with less restriction of said agencies, but experimental economics suggests you can have a sparsely populated market and still get much of the benefits of "perfect markets" that economists have worked out [1].
A naive public choice model suggests why things will fail: conflict in incentives. Public choice makes the seemingly underwhelming assumption that people are people, and works out consequences of this assumption. Special interests can aggregate enough power to effect rating agencies to meet the special interests needs rather than the institutions involved. Factions within companies, stockholders, and individuals at leveraged positions will have personal incentives to game the system. Further, only the stockholders, or the company itself, will have incentive to pay for ratings: both of which may have reason to have overly rosy ratings [2].
The obvious solution is to have each and every consumer of companies’ products to share in the cost. We currently have this situation - it is called regulation, the costs of which are passed on to consumers and taxpayers [3]. What is the difference between regulation and a rating company? Admittedly, only a matter of degree: special interests groups also have incentive to influence the regulation, but here we will have more competition among interest groups, tending to cancel each other out [4]. This idea underpins James Madison’s theory of republics.
Ratings agencies have incentive to be right, and companies have incentives to have solid (and real) ratings: both survive due to reputation. But there are strong short-term incentives for numerous players within the corporations (both raters and ratees) to game reputation and trust for personal advantage.
Public choice tells us to beware of having overly romantic views of government, as "government failure" can occur due to incentive mismatch. Public choice also suggests that corporations [5] have a similar route to failure: treating an aggregate as an entity with self-interest is a poor way of predicting what will happen, and assuming a romantic view of selfless individuals taking on the persona of that aggregate institution is a limited reflection of reality.
Sure, it may be in a companies “self interest” to maintain “its” reputation, but a company cannot act – only people within that company. And people can be tempted. Yes, most people feel a duty to their country, their corporation, their church, their friends - but they are people, and will have incentives that tend to undercut selfless duty [6]. We see this again and again - sexual abuse scandals in the church and in schools, corporate scandals, and governmental failures. By identifying institutions as selfless entities working for good, and individuals within those institutions as taking up the banner of pure duty to fulfill that good, we set ourselves up for disappointment.
Notes:
[0] Or at least they claim to believe. Often their actions undercut this claim, as in the example of "pure libertarian" professors (Taxing is an evil? evil? And your salary and lifestyle comes from what? Oh, yeah, "evil". You must mean "minor annoyance", excuse me while I discount most of your arguments as you seem to be a bit hyperbolic...).
[1] But make unlikely assumptions such as: infinite number of companies, everyone having perfect information, and people making purely rational decisions. Not that these assumptions are actually seriously thought to be needed, or are even meaningful.
[2] Potential investors do have an incentive to get the truth, but here the free rider problem prevents potential investors from paying for a study - better to have someone else pay for a study and get the results for free. Ditto for consumers, as the next paragraph discusses.
[3] This whole group payment is fundamental to the idea of "insurance" - what we often call insurance is both insurance against risk, as well as a mechanism to level the variation in costs by grouping people together. This pooling payment scheme is a crucial idea that is at the heart of how we run society. There are problems with it - try evenly splitting a bill at a restaurant instead of having each pay for themselves and see the steaks and fancy drinks flow - but there are issues with its absence also - public goods are goods. Consider a society without clean drinking water or roads. The floor of a society dictates how much one can move up; if everyone around you has TB, cannot read, and only the rich can move on a private road you have significant training costs, risks (health, violence, etc. etc.), transaction costs, etc. and one can imagine serious limits on both personal improvement and the rate of social improvement. Being taxed and getting public goods like sanitation is far better than the "freedom" of not having them.
[4] Further, as there is a single "player" transparency, in principle, is easier to maintain. In practice this will only occur to the extent that responsibility is clear and efforts are taken to provide transparency.
[5] Indeed, in general, the similarity between a corporation and our modern society is pretty high.
[6] At the very least, a subset of people will feel this pressure. If they also believe that such behavior is justified they be attracted to such positions and look for such opportunities.
