Over the last couple of decades, it has become increasingly apparent to me the concept of transparency is too complex for Economists.
Economists tend to be very bright individuals. However, when it comes to transparency, they seem to have an incredibly hard time understanding it. This is true even after they have seen my physical model of financial transparency that uses a clear plastic bag security and a paper bag security. There could be a couple of reasons for this.
First, to paraphrase Upton Sinclair, it is difficult to get an Economist to understand something, when his lofty salary/consulting fees depends on his not understanding it. Clearly, Wall Street’s Opacity Protection Team has purchased a lack of understanding from any number of Economists at even the most famous universities.
Second, a surprisingly large number of Economists simply assume it exists. In the financial markets they point to all the disclosure regulations. When you suggest these might not be adequate, they turn to their belief in theories like the Efficient Market Hypothesis (under the strong form of this hypothesis, the price reflects all information whether it has been disclosed or not).
Regardless of the reason, Economists left groundbreaking research in Information Economics open to non-Economists like myself. The result of my research was the Information Matrix.
|Does Seller Know What They Are Selling?|
|Does Buyer Know What They are Buying?||Yes||No|
|Yes||Perfect Information||Antique Dealer Problem|
|No||Lemon Problem||Blind Betting|
In the upper left quadrant labeled Perfect Information, we find financial transparency. Both buyer and seller can make a fully informed decision because they have the transparency of a clear plastic bag. This corner also happens to be the foundation on which all of economics and finance is built. It is only when transactions take place in this quadrant their theories hold.
In the lower left and upper right quadrants, we have information asymmetry. One party to the transaction has the transparency of the clear plastic bag and the other party is betting on the unknown contents of a paper bag. The problems associated with information asymmetry are readily apparent when you realize one party is dealing with opacity.
Finally, both buyer and seller are blindly betting on the unknown contents of a paper bag security in the lower right quadrant. This quadrant exists and is very active for financial securities (examples include bank and subprime mortgage-backed securities). Wall Street is loaded with great storytellers who phish for fools based solely on a story about what the value of the opaque securities in the Blind Betting quadrant might be.
The Information Matrix shows where financial crises comes from, how to stop them and how to prevent them.
Financial crises originate in the Blind Betting quadrant. Financial market participants have only story driven guesses as to the value of the opaque securities in this quadrant. Financial crises and their associated “runs” occur when market participants come to doubt the story and their guess as to the value of the opaque securities they own. In the absence of facts, when doubt sets in there is no logical stopping point in the downward valuation of these securities other than zero. Investors know this and this gives them an incentive when doubt starts to set in to “run” and try to get their money back.
The Information Matrix also shows why transparency is too complex for Economists. For example, in a recent speech on transparency at the Bank for International Settlements, the Governor of the Bank of Finland observed,
Is there an area, where more is not always better? …
Bengt Holmström, last year’s Nobel Laureate in economics, has pointed out that in some cases transparency can be counterproductive. His point is that, in asset markets, too much transparency can lead to a loss of liquidity compared to situation where all market participants would view some asset class as homogeneous because of their opacity.2
The paper cited was presented at the August 2008 Jackson Hole Conference on Maintaining Stability in a Changing Financial System.
The Nobel Laureate subscribes to the what I like to call the Goldman Sachs Theory of the Perfect Financial Market. This market is comprised of investors blindly betting on “homogeneous” opaque securities based solely on stories told by Wall Street. So long as the valuation story isn’t called into doubt, there are investors to buy both newly issued and existing opaque securities.
Unfortunately, the Goldman Sachs Theory of the Perfect Financial Market has a major flaw in it when it comes to the issue of maintaining stability. The flaw is what happens when the valuation story is called into doubt. In the absence of transparency, there is no logical stopping point in the downward valuation of these securities other than zero. Without a logical stopping point, there are no investors to come in and stabilize the market when prices start to fall.
Clearly, the events of September 2008 debunked the Goldman Sachs Theory of the Perfect Financial Market that too much transparency can lead to a loss of liquidity.
We saw the financial system fracture along the opacity fault line exactly as predicted by the Information Matrix. When the valuation story for the opaque securities was called into doubt, buyers for these securities disappeared as there was no logical price to step in and buy these securities at.