Sepp Blatter was asked during his visit in Israel about Israel's unrealistic FIFA ranking.
Here's his answer (from The Jerusalem Post):
"We used to calculate the ranking with a university formula and help from experts, but then we decided to implement a similar system to the one the ATP uses," Blatter explained.
"I don't know why you're complaining? You're 16th in the world.
"If anybody's got a better system to rank the teams, please tell me about it."
Perhaps Mr. Blatter should take a look at these ranking systems:
World Football Elo Ratings
Based on the Elo rating system, developed by Dr. Arpad Elo. Here's the system behind the rankings.
AQB International Soccer Ratings
Developed by Michael Cameron of the University of Waikato (New Zealand). More details on the system.
Voros McCracken's International Team Ratings
Developed by Voros McCracken. He's famous in the world of baseball for his Defense independent pitching statistics work. The starting point was KRACH (Ken's Ratings for American College Hockey), "an implementation of a sophisticated mathematical system known as the Bradley-Terry rating system". It is the single iterative system of the three I've listed. It is also my favourite, but unfortunately Voros stopped updating it after May 2007 due to other commitments and right now I don't have the time to implement it.
Update 30 October 2008:
As I already mentioned, KRACH is just the starting point. Here's what Voros said about the system:
"However a bunch of modifications were made to how to do the iterations, home field advantage, partial wins awarded based on scores and also a separate system that evaluates teams based on goals instead of wins and losses. These systems also account for how long ago the match took place and also the type of match it was (IE, friendly, World Cup Qualifier, World Cup Final, etc.)
The idea is at the end of all of the iterations, the predicted win percentage for the teams in their games based on their ratings is the same as their actual. So that if a team wins 85% of their games, the ratings are such that if you add up all of the expected results that's the win percentage the team will have.
Ultimately I believe iterative methods are the best and most reliable way to encompass all of the data. If you don't do an iterative method, it's difficult to go back and interpret past results based on new information (eg, if you lose to Ghana one week when they're rated low and then next week they beat Brazil, that information should be used to re-evaluate what losing to Ghana means. A system like ELO doesn't do that).
Testing of the system against actual results tends to have it do slightly better than ELO and significantly better than FIFA."