Tim Congdon, Chairman of the Institute of International Monetary Research, laid down the challenge for what the Economics profession needs to learn:

The main intellectual challenge for economics now, just as it was when Keynes was writing, is to identify how the banking system—with its alleged masters of the universe, and its undoubted manias, delinquencies and pathologies—interacts with the rest of the liberal capitalist democracies of today.

If the Economics profession used the Information Matrix, this challenge shouldn’t be too hard to overcome.

If you were going to build a financial system from scratch, in which quadrant of the Information Matrix would you like 100% of the activity to occur?

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

If you work on Wall Street, you would like all the activity to occur where buyers and sellers are blindly betting (the Blind Betting quadrant).  While this is good for Wall Street, there is no reason to think this is good for anyone else.

The quadrants defined by information asymmetry (Lemon Problem and Antique Dealer Problem) are similarly flawed.

This leaves only one remaining quadrant and I think we can all agree we want 100% of the activity to occur in the Perfect Information quadrant.

It is only in this quadrant that investors are truly able to make the fundamental risk/return assessment that drives the efficient allocation of capital across our economy.

It is only in this quadrant the investors’ trust in their own risk/return assessments translates to confidence in the global financial system.

It is only in this quadrant, caveat emptor (buyer beware) takes place and investors limit their exposure to any asset to what they are comfortable losing given the asset’s risk.

Reform of the US financial system during the Great Depression focused on the need for information. It was heavily influenced by Justice Brandeis’ observation “sunlight is the best disinfectant”.  But it was more heavily influenced by the Pecora Commission’s finding “opacity is Wall Street’s best friend”.

According to the Congressional Oversight Panel:

From the time they were introduced at the federal level in the early 1930s, disclosure and reporting requirements have constituted a defining feature of American securities regulation (and of global financial regulation more generally).

President Franklin Roosevelt himself explained in April 1933 that although the federal government should never be seen as endorsing or promoting a private security, there was ―’an obligation upon us to insist that every issue of new securities to be sold in interstate commerce be accompanied by full publicity and information and that no essentially important element attending the issue shall be concealed from the buying public.’

By design, our financial system limits falling prey to Wall Street’s storytelling and blindly betting. It does this by providing transparency.  Transparency allows both buyer and seller to do their own due diligence so they can either ignore or “Trust, but Verify” Wall Street’s storytelling.

So what is the role of the liberal capitalist democracies in the financial system we would design from scratch and was put in place during the Great Depression?

The role is to ensure transparency so investors could know what they owned.

Initially, the government took on this role.  It was administered by the SEC.  As shown by the Great Financial Crisis, the SEC was not up to the task.  At the heart of the Great Financial Crisis were opaque securities (including subprime mortgage-backed deals and the Too Big to Fail banks). The existence of these securities demonstrated Wall Street was able to capture the process by which the SEC set disclosure requirements.

Since the SEC was not fit for purpose, the liberal capitalist democracies need a different platform for ensuring transparency is provided.  This platform must be immune to capture by Wall Street.

Fortunately, the private sector has created this platform.  It is the investor supported Transparency Label Initiative.

There are pros and cons to the Initiative.

On the plus side, the Initiative does not have to concern itself with many of the issues like the cost of providing disclosure that undermined the SEC. As a result, investor can trust for investments which qualify for a label they will be able to know what they own.  Therefore, investors can determine for themselves how much of their portfolio, if any, they are willing to engage in blind betting on opaque investments.  To the extent investors limit their exposure to blind betting, they force activity into the Perfect Information quadrant.

On the negative side, the Initiative cannot mandate disclosure.  By not assigning a label to an investment, the Initiative can signal buying or selling the investment is blindly betting.  But it cannot mandate the level of disclosure the investment must provide to qualify for a label indicating investors could know what they own.  The Initiative relies on market discipline to force disclosure.  In particular, the Initiative relies on investors to demand a higher rate of return on investments that don’t qualify for a label.  This gives issuers an incentive to lower their costs by providing disclosure so an investor can know what they own.