As I was reading a Bloomberg column by Noah Smith, I was reminded of the simple fact the economics profession doesn’t fully understand transparency.

Yes, it understands the notion of perfect information where both buyer and seller have all the information they need to make a fully informed decision.  It is this notion of perfect information that underlies economics and the idea the Invisible Hand operates to properly set prices.

Yes, the economics profession also understands information asymmetry.  Nobel Prizes have been awarded for describing the case where the seller has more information than the buyer, George Akerlof’s Lemon Problem, and the buyer has more information than the seller, Joseph Stiglitz’s sellers leaving market if sense they will be taken advantage of by better informed buyer.

What the economics profession doesn’t understand is there exists yet another possible information condition where neither the buyer nor the seller has the information they need to know what they are buying or selling.  This condition is shown in the following information matrix:

Please note, just because the economics profession doesn’t discuss both buyer and seller engaging in transactions where they don’t know what they are doing doesn’t mean these transactions don’t occur with regularity.  In fact, they do and most often Wall Street is the primary beneficiary of the transaction occurring.

Let me give you an example of where this has and continues to happen: subprime mortgage-backed securities.  These deals are opaque.  As a result, neither the buyer nor the seller has any way of knowing what they are buying or knowing what they are selling.  However, Wall Street made a lot of money acting as the intermediary between buyer and seller and selling trillions of dollars of these securities.

Let me give you another example: the Too Big to Fail banks.  These banks are black boxes.  As a result, neither the buyer nor the seller has any way of knowing what they are buying or knowing what they are selling.  Again, Wall Street makes a lot of money acting as the intermediary between buyer and seller.

The reason the Transparency Label Initiative exists is to remind investors when they are blindly gambling on opaque securities.  Hopefully, this will minimize the amount of financial activity where Wall Street maximizes its profits and will maximize the amount of financial activity where the Invisible Hand works properly.