In Transparency Games, I get to talk about how economists, both academic and those working for the financial regulators, have theory-induced blindness when it comes to how financial markets actually work.

Theory-induced blindness is the application to economists of Upton Sinclair’s line, “It is difficult to get a man to understand something, when his salary depends upon his not understanding it.”  For economists, it is reflected in their inability to see what is actually happening in the financial markets when it contradicts their beautifully derived theory.

In talking about his idea of theory-induced blindness, Daniel Kahneman said

The mystery is how a conception that is vulnerable to such obvious counterexamples survived for so long. I can explain it only by a weakness of the scholarly mind that I have often observed in myself. I call it theory-induced blindness: Once you have accepted a theory, it is extraordinarily difficult to notice its flaws. As the psychologist Daniel Gilbert has observed, disbelieving is hard work.

The efficient market hypothesis (EMH) is the classic example of a theory that was widely accepted and, as a result, it became extraordinarily difficult for economists, both academic and those working for the financial regulators, to notice its flaws.  Flaws that were revealed by the financial crisis.

EMH looks at the issue of how financial market prices reflect the available information.  EMH has 3 forms; the strongest of which asserts that even information that is hidden from most market participants is reflected in the price.  EMH effectively says that even in the absence of transparency, prices reflect what would occur if transparency existed.

For their original tests of the theory, economists chose the most transparent financial market in the world.  A financial market which also just happens to have restrictions on insider trading.  That market was the US stock market.  Prices in this market confirmed the theory.

Unfortunately, the US stock market is currently a special case.  This was clearly shown by the financial crisis when the market for private label mortgage-backed securities effectively froze and the price for these securities dropped significantly (think from the 80s to the 20s).  The price for these opaque securities on Day 1 didn’t reflect their underlying fundamentals.  Fundamentals which due to a lack of transparency the buyers did not have access to.  Rather, the price buyers paid reflected the maximum price Wall Street could obtain based on the story it told about the underlying fundamentals.  Wall Street had an incentive to maximize the price because it pocketed the difference between the price it sold the securities at and the price it paid for the mortgages it bundled into the securities.

The financial crisis also showed that within the US stock market EMH did not hold for all stocks.  In particular, it did not hold for bank stocks.  Why?  Given how they are paid, there is no reason to think that bankers would not try to maximize their compensation by hiding the losses sitting on and off their balance sheet.  They could do this because, as the Bank of England’s Andrew Haldane said, banks are black boxes.

One of the benefits of the Transparency Label Initiative™ is it addresses theory-induced blindness when it comes to the EMH.  Specifically, it ensures there is the transparency in the financial markets that the theory assumes is there.