Kenneth Arrow and the Information Matrix
Nobel prize winning Economist Kenneth Arrow’s 2008 insights into the financial crisis highlighted a giant hole in standard economic theory.
Professor Arrow observed the root cause of the Great Financial Crisis was “large differences in information among market participants”. However, his interpretation of this observation is limited by the glaring omission in the Economic profession’s understanding of information.
He begins with the idea spreading risk is a good for society.
There have been two developments in the economic theory of uncertainty in the last 60 years, which have had opposite implications for the radical changes in the financial system. One has made explicit and understandable a long tradition that spreading risks among many bearers improves the functioning of the economy.
However, he saw circumstances under which this wasn’t true.
The second is that there are large differences of information among market participants and that these differences are not well handled by market forces.
Please note, Professor Arrow recognizes markets by themselves don’t correct for informational problems. This bears repeating. Markets do not correct themselves for informational problems. This has always been a problem solved by government.
Regular readers are not surprised by this. This was demonstrated in the early 1930s by the Pecora Commission when it showed investors were not able to demand the information they needed to know what they own. The result of this finding is the FDR Administration passed the Securities Act making it the SEC’s responsibility to ensure publicly traded securities provide sufficient disclosure so an investor could know what they owned.
What initially surprised me is Professor Arrow then goes on to describe the distribution of information as seen through the lens of asymmetric information.
The second strand of analysis was a growing recognition of the importance of information in governing reactions to uncertainties. If individuals in the market have different degrees of information, the ability to create securities or engage in other forms of contracts becomes limited; the less informed understand that the more informed will take advantage and react accordingly.
To Professor Arrow, “limited” is equivalent to less informed investors won’t buy securities from Wall Street when they think they are going to be taken advantage of.
But why does Professor Arrow use the lens of information asymmetry?
The reason he does is the Economics profession hadn’t progressed then and still has progressed today beyond asymmetric information. The idea investors trust Wall Street and buy/sell opaque securities based on an unverifiable valuation story is missing from standard economic theory.
Allow me to use the Information Matrix below to illustrate the profession’s view:
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 | |
Economists, including Mr. Arrow, are only aware of 3 of the 4 quadrants of the matrix. The Perfect Information quadrant is the quadrant in which all of their theories work. The information asymmetry quadrants (Lemon Problem and Antique Dealer Problem) are the quadrants the Economics profession has found to date where their theories don’t work.
Completely missing from the Economics profession is the Blind Betting quadrant and the idea investors buy/sell opaque securities based solely on a story told by Wall Street.
Examples of these opaque securities include bank unsecured debt and equity securities. Former Fed Governor Kevin Warsh confirmed this when he observed about bank disclosures:
Investors can’t understand the nature and quality of the assets and liabilities… The disclosure obfuscates more than it informs.
Hedge Fund manager Paul Singer seconded the motion these securities are opaque by bluntly saying:
The unfathomable nature of banks’ accounts make it impossible to know which are sound. Derivatives positions, in particular, are difficult for outside investors to parse.
In fact, standard economic theory assumes away the Blind Betting quadrant under the Efficient Market Hypothesis. Under this hypothesis, all available information is reflected in the price for a security. Include under “all” available information is the information insiders would be privy to.
This is a nice hypothesis, but what happens if a security is created that doesn’t have insiders? The hypothesis no longer holds true.
Examples of this type of securities are structured finance securities where assets, like subprime mortgages, are placed in a trust for the benefit of the investors.
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