The following is an excerpt from Transparency Games highlighting just how misunderstood transparency is by the Economics profession:
Recall that, including myself, there were only a small handful of economists and other individuals who could say they actually warned about the financial crisis and therefore had an insight into why the crisis occurred. Based on this insight, these individuals offered up solutions on how to moderate and end the financial crisis.
However, these solutions were crowded out by the army of economists who didn’t predict the financial crisis, but were only too willing to offer up their insights about the financial crisis. Without attaching a warning saying their understanding of the causes of the financial crisis might be suspect due to their failure to predict the crisis, this army of economists provided their solutions for either ending the crisis or their opinions for how the financial system should be reformed as a result of the crisis.
Nowhere was this crowding out better exemplified than when six Nobel-prize winning economists endorsed the retention of opacity in the financial system. The Nobel-prize winning economists included Harry Markowitz, Robert Merton and Myron Scholes. Alan Greenspan credited the work of this trio as the genesis for the risk-management paradigm that failed at the beginning of the financial crisis. The other Nobel-prize winning economists who endorsed retention of opacity in the financial system were Robert F. Engle III, William F. Sharp and Vernon Smith.
They endorsed the retention of opacity in the financial system by signing a letter from the Committee to Establish the National Institute of Finance calling for a government agency to see into all the opaque corners of the financial system.
The recent financial crisis has revealed fundamental gaps in our understanding of financial markets and how they affect the broader economy. These gaps were evident in the inability of regulators and policy makers to see the buildup of systemic risks that led to the recent crisis and to understand the potential impact of their decisions at the most critical times of the crisis.
Going forward, a significant regulatory weakness is the absence of a sustained effort to gain a deep understanding of risks to the financial system, including the lack of essential data and the analytical capacity to turn that data into useful information to enable regulators to better safeguard our financial system…
There has been far too little attention devoted to strengthening the research efforts and fixing the inadequate data and analytical capability on which sound regulatory decisions must be based.
In his opening comments to the Senate Banking Committee, on June 18, 2009 Secretary Geithner commented, “We must be able to look in every corner and across the horizon for dangers and our system was not able to do that.” In spite of this observation, the bill that recently passed the U.S. House of Representatives does nothing to provide authority to collect system-wide data or to provide the permanent staff and resources needed to develop these critical capacities.
To be successful, legislation intended to equip the government to understand and monitor systemic risk and be able to reduce the risks of major financial crises in the future must include provisions to strengthen research efforts and provide the government with previously unavailable data and analytical capabilities.
Over the past year a large group of academic scholars, regulators, and financial sector experts, calling themselves the Committee to Establish the National Institute of Finance (CE-NIF), came together in a volunteer effort to develop a proposal for how to enable the government to develop the research capacity and acquire the data and analytical capability to remedy this glaring regulatory weakness.
We strongly urge you to include in the U.S. Senate’s financial regulatory reform legislation the authorities and resources needed to assure that the U.S. government will have the understanding, data and analytical capabilities proposed by the CE-NIF that are necessary if government regulators are to have the tools needed to safeguard the U.S. financial system.
With their endorsement, the agency for monitoring systemic risk was created as part of the Dodd-Frank Act. It is publicly known as the Office of Financial Research. To the Wall Street’s lobbyists who drafted this part of the Act and myself, it is referred to as the agency where the economics profession sent the philosophy of disclosure and valuation transparency to die.
Compare and contrast how our financial system based on the combination of disclosure and caveat emptor operates with what the six economic Nobel laureates requested in their letter to fix what the letter acknowledges is a problem of opacity in the financial system.
They requested that the Office of Financial Research be set up specifically so the government has access to the information necessary for assessing risk in the global financial system. It is the government regulators who are suppose to then assess this risk. It is the government regulators who are suppose to then take steps to address the risk so another systemic financial crisis is avoided.
The Nobel laureates embraced the idea the financial regulators should take over the process by which the collective assessment of risk by all market participants is reflected in their exercise of self-discipline and the enforcement of market discipline. Going forward, it is the financial regulators’ responsibility to assess risk and enforce self-discipline.
Think for a second just how complicated it would be to assess the risk of financial contagion in the financial system and then manage each market participant so financial contagion doesn’t occur.
By definition, the idea of financial contagion is one market participant fails and their failure triggers a domino-style cascade of failures throughout the financial system. To properly assess the risk of financial contagion quite literally requires understanding every market participant’s current direct and indirect exposures to every other market participant and being able to assess which market participants have a greater level of total exposure to another market participant than they can afford to lose. To eliminate financial contagion would require that the regulators step in every time a market participant has a greater level of total exposure to another market participant than they can afford to lose.
These six prominent economists recommended putting this complex burden on financial regulators as a substitute for simply making valuation transparency available to all market participants in what are all the currently opaque corners of the financial system and letting the financial system operate as designed under the FDR Framework.
Investors, knowing they are responsible for all losses on their investment positions, have an incentive to limit the size of these positions to what they can afford to lose. However, investors can only do this when they have valuation transparency and can independently assess the risk of each of their investments. By bringing valuation transparency to all the currently opaque corners of the financial system, investors can perform their risk assessment and then adjust the amount of their exposure. This ends the risk of financial contagion.
If there is anything the economics profession should understand and be able to provide useful advice on, it is the importance of valuation transparency as the necessary condition for the invisible hand of the market to operate properly and set prices that efficiently allocate resources.
If there is anything the economics profession should understand and be able to provide useful advice on, it is the importance of valuation transparency to the investment process so that there is both market discipline and the elimination of financial contagion.
So what did six of the most highly acclaimed living economists do when they were effectively speaking for the entire economics profession and stepped up to address the problem of opacity in the financial system?
Collectively they failed to recognize the need to bring valuation transparency to all market participants and not just regulators. Together they effectively recommended retaining opacity in the financial markets and making it the regulators’ responsibility to ensure all the benefits the combination of valuation transparency and caveat emptor deliver like eliminating financial contagion and market discipline.
By failing to recognize the response to opacity is valuation transparency, the six Nobel-prize winning economists’ recommendation crowded out the voices calling for valuation transparency.
I know this crowding out occurred because for several months before the passage of the Dodd-Frank Act, I talked with both Congressional staffers and the leadership of the Committee to Establish the National Institute of Finance.
I used the clear plastic and brown paper bags to explain why valuation transparency was necessary and the Office of Financial Research was the wrong solution. Of course, the leadership of the Committee rejected my argument. Congressional staffers pushed back against the clear plastic bag and valuation transparency by pointing to the Nobel-prize winning economists and the large group of academics, regulators and financial sector experts calling for the Office of Financial Research.
When I pointed out to the Congressional staffers the Office of Financial Research does not provide valuation transparency so market participants can know what they own, the staffers pushed back using the Wall Street’s Opacity Protection Team’s claim that disclosing this data would create information overload for investors.
When I pointed out that investors didn’t have to analyze the data themselves, but could use third party experts who could analyze the data, the Congressional staffers pushed back with if investors having valuation transparency was important, six Nobel-prize winning economists and the Committee would have pushed this idea instead.
In 2012, I met with one of the individual who led the Committee to Establish the National Institute of Finance. Having seen how the Wall Street Opacity Protection Team used the Office of Financial Research to cement opacity into the financial system, he apologized for not listening to me.
 Committee to Establish the National Institute of Finance (2010, February 11), Letter to the Honorable Christopher J. Dodd, Chairman Committee on Banking, Housing and Urban Affairs, http://www.ce-nif.org/images/docs/nif_ltr_to_sen_dodd.pdf