The Information Matrix sheds new light on a decades long argument between Nobel prize winning Economists Joseph Stiglitz and Milton Friedman.  The argument centers on Friedman’s observation in Capitalism and Freedom:

there is one and only one social responsibility of business — to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition, without deception or fraud.

Friedman argued this observation was the natural extension of Adam Smith’s Invisible Hand.  This observation underlies the free market ideology and notions like pursuing market efficiency makes everyone better off.

This observation is also a classic example of PhD Economist Derp as practiced by a Nobel prize winner.  The way Friedman phrases his statement, you would think this was how businesses naturally conduct business.  Therefore, if you leave business alone, society will be better off.

He buries the fact for the Invisible Hand of the market to work for the benefit of society certain assumptions must be true.  The first and most important of these assumptions is buyers and sellers have all the information they need to make a fully informed decision.  In the Information Matrix, this occurs only in the Perfect Information quadrant.

Information Matrix

Joseph Stiglitz spotted a situation under which the Perfect Information assumption wasn’t true.  He identified the Antique Dealer Problem quadrant.  In this quadrant, information asymmetry favors the buyer over the seller.  In the case of antiques, the dealer knows much more about the value of the antique than does the seller.  If the antique dealer maximizes profits, it means taking advantage of the seller.  This raises questions as to how other stakeholders like society as a whole benefit from this transaction.

Professor Stiglitz and Milton Friedman can only engage in their disagreement because they both managed to miss the most important quadrant in the Information Matrix.  A quadrant that just happens to put the brakes on free market ideology and explains why the Visible Hand of government is needed to constrain all markets.

The quadrant they missed is the Blind Betting quadrant.

In assessing what went wrong with the financial system in the run-up to the Great Depression, the Pecora Commission found Wall Street didn’t act in the socially responsible way Friedman suggests businesses will act.  Wall Street relied on opacity to hide deception and fraud.  Wall Street benefitted from selling securities in the Blind Betting quadrant.  By themselves, Investors were not able to exert enough influence on issuers, including banks, to ensure disclosure so the investors could know what they owned.

So in the 1930s, the financial system was redesigned to minimize transactions that occur in the Blind Betting quadrant.  It did this by introducing the Visible Hand of government.  Specifically, the SEC was created and given responsibility for ensuring a minimal level of disclosure.  The goal was for the SEC to push transactions into the Perfect Information quadrant.

Of course, by missing the Blind Betting quadrant and why the financial system is designed the way it is, these two Nobel prize winning Economists missed the most obvious example of why free markets need to be constrained by the Visible Hand.  They also missed why removing the Visible Hand would not increase the benefits society received from free markets, but rather would leave society worse off.