• Paul Romer:  Sure. But perhaps better in a blog post?

Here is the link to the post I wrote and here is the specific rebuttal of the idea “sometimes better not to have some types of information” in the financial system.

While the financial system FDR and his administration introduced produces numerous benefits, let me focus on three of them:

1. It subjects issuers of securities to market discipline.  If their risk goes up, so too does the cost of their securities as investors reduce their exposure based on the changing risk/reward of the investment.

2. It eliminates the need for bailouts.  All investors, and this includes banks, know they are responsible for the losses on their investments.  As a result, they know they should limit their exposure to any investment to what they can afford to lose on that investment given its risk.

3. It allows those investors who are best at assessing the risk/reward of a security to effectively set the price range for the security.  This limits the misallocation of resources due to an individual security or a category of securities being mis-priced.

This is the system FDR and his administration put in place in response to the Great Depression.  But what system was in place before that?  It was a system based entirely on caveat emptor.  In this system, it was assumed buyers would force issuers to disclose all the needed information.  FDR and his administration learned from the Roaring 20’s and the Pecora Commission investigation into the subsequent financial market collapse this wasn’t true.  Hence, they introduced transparency and made it the responsibility of the government to ensure it was provided.

So back to explicitly debunking the notion sometimes it is better not to let investors have access to all the information they need to assess the risk/reward of a security.  By definition, when we don’t let investors have all the information they need, we are talking about an opaque security.

Is there any reason to think buying and selling opaque securities delivers the same three benefits listed above?  No.

How exactly are investors suppose to enforce market discipline on issuers to restrain risk taking if they don’t know what they are buying and cannot assess its risk?  They cannot.

Since they weren’t provided access to the information they needed to assess the risk of the investment, what prevents investors from taking on too much exposure?  Furthermore, why shouldn’t they look to the government/taxpayers to bail them out of the losses on their opaque security bets? As shown by the financial crisis, investors will take on too much exposure and want to be bailed out for losses on their bets on opaque securities.

Why should buyers and sellers properly allocate resources when they are engaged in blindly betting on securities where they can neither assess the risk or reward?  There is no reason this should result in the proper allocation of resources other than sheer luck.  We know the necessary condition for the Invisible Hand of the Market to operate properly is both buyer and seller have access to the information they need.  If this weren’t the necessary condition, we are left with the idea blindly gambling and informed decision making yield the same economic outcome.

Finally and perhaps most importantly, we relearned in the financial crisis that began on August 9, 2007 opacity is the necessary condition for a financial crisis.  Financial markets freeze/collapse where there are opaque securities. Look at which parts of the capital markets froze/collapsed during 2008/2009.  Each of them involved opaque securities (including mortgage-backed bonds and unsecured bank securities like inter-bank loans).  In the absence of information, once fear over the value of a security sets in, there is no logical stopping point in the decline of the security’s value other than zero.  Hence, prices collapse as investors race to get their money out (think bank runs on opaque banks).

Where the capital markets didn’t freeze during the peak of the panic in 2008/2009 there was transparency.  This wasn’t surprising as buyers could assess the risk/reward, i.e. value the securities, and sellers knew what they owned.