Trust vs. Transparency: What the Market Needs Now

All the various flavors of economists can have fierce debates over issues such as the proper role of government. Libertarians might stake out one extreme position, someone will argue the other side, and there are always at least a few who will take the middle ground. But when it's a policy issue of critical importance, such as in the wake of a financial crisis, the differences among us are much less apparent.

Transparency -- the availability of essential information about the market -- is needed for markets to function optimally. A key point of this argument from Arnold Kling, is that financial markets replace transparency with trust by necessity, and this makes financial markets inherently unstable. The problem is that trust is fragile, it can be broken easily, and thus some sort of insurance is needed to overcome lack of trust and keep these markets functioning smoothly.

One way to do this is through government provided deposit insurance, and I fully agree that this is a critical element in maintaining trust in financial markets (and as noted below, not all events can be anticipated and this means that some interventions to provide the necessary insurance will necessarily be ad hoc). But the main point I want to emphasize is that government must step in when there is a danger that trust will be significantly eroded by the failure of financial markets:

What Should Government Guarantee?, by Arnold Kling: ...On financial markets, I am in the middle between the Progressive view that government can guarantee everything and the libertarian view that the government should guarantee nothing.

My view is that financial markets are inherently unstable, because financial intermediation inherently replaces transparency with trust. If my bank were perfectly transparent, then I would know everything about its loans, including the underlying risks of the real estate developers, small businesses, and individuals to whom it is lending money. But in that case, I would not need a bank--I could just make those loans myself. So if you assume perfect transparency, you assume away the need for financial intermediation.

In fact, you have to assume the opposite of perfect transparency. You have to assume highly imperfect transparency, with reputation and trust serving as substitutes. In banking, deposit insurance helps facilitate trust. A private insurance pool might work, but people trust government-provided deposit insurance even more.

With deposit insurance, the consumer loses all motivation for worrying about the bank's risk management. By the same token, the insurer has to worry a lot. In the U.S., the FDIC has been getting better over the years, but you can never get complacent. Any system can be gamed eventually, so it's a challenge for the regulators to stay one step ahead of the banks.

What we see with Bear Stearns (BSC), Freddie (FRE) and Fannie (FNM), Lehman (LEH), and AIG (AIG) insurance are institutions that are not FDIC-insured banks where nonetheless a question arises about whether some of their creditors ought to be protected by the government. I think that just about everyone is unhappy that these decisions are being made ad hoc, after the firms got in trouble, rather than having rules set ahead of time. But maybe what the government is doing is actually pretty reasonable. ...

Overall, I think that having some regulated, insured institutions, like the banks, is good. I don't think we can or should try to regulate everyone. Regulators should try to anticipate crises and prevent them. But almost by definition, the crises that do occur will be ones that they did not anticipate, and the responses will have to be somewhat ad hoc.

My grandmother lived through the Great Depression. After she passed away, we found money hidden all over her house -- I'm sure there was some we never found, maybe buried in the yard or something. Even with deposit insurance, after the experience of the Great Depression she never trusted banks again, and nothing could convince her otherwise. That lack of trust takes assets that could be used productively to finance investment projects and hides them in the house or yard.  And when you spread this behavior over millions and millions of people, the result is lower investment and lower growth.

In addition, when trust evaporates, the withdrawal of assets from the financial system is not limited to households with relatively modest savings worried about their bank deposits. People and businesses with large accumulations of assets do the equivalent of hiding their money in the cookie jar, and this can cause investment markets to dry up very fast. And as my grandmother's case shows in its own small way, once trust is gone it can take a long time to be reestablished, if ever.

The consequences of a big financial crash are not necessarily temporary, it is not simply a case of wiping out that which needs to be creatively destroyed and moving on, the damage to trust can be permanent, and if it is, the consequence will be lower investment, lower growth, and fewer jobs than if the trust-busting crash had been prevented. The cost of, say, a quarter percent lower growth for 25 years is large, far larger than the cost of a typical bailout, and the costs do not fall solely on those who made the choices that caused the problems, the costs fall on all of us.

Update: Given the above, and this, it shouldn't be a surprise that I think this is a good idea:

Fed Readies A.I.G. Loan of $85 Billion for an 80% Stake, NYT: In an extraordinary turn, the Federal Reserve was close to a deal Tuesday night to take a nearly 80 percent stake in the troubled giant insurance company, the American International Group, in exchange for an $85 billion loan, according to people briefed on the negotiations.

In return, the Fed will receive warrants, which give it an ownership stake. All of A.I.G.’s assets will be pledged to secure the loan, these people said. ...

Disclosure: None

Comments

[pochovilla:]

Transparency could be provided quickly if the attorney's don't wordsmith too much. Trust takes a long time to build once it is violated.

2008 Sep 17 11:00 AM

[Jason Rines...:]

My Grandmother taught me a famous quote as well and lived through the Great Depression (is that why they loved beats and beans so much?):

"Never trust a banker, they love foreclosures."

Regulators are controlled by Washington politicians whom these days are large self-serving. It's really more or less a Feudalistic government we are seeing or call the government type Fascist. Trust is intilled by management be it political or business. That is already broken globally and out the window. To restore confidence at the top levels, a large portion of the corrupt in Washington must go. The American citizen is not ready to do this, they bite into promises of a Presidential candidate that promises to fix things when you and I know the true power of legislation/regulation falls to the House of Representatives. A President is a veto pen a spokesman. The American people will see much pain in the next few short years and will research which politicians in the House are the worst of the corrupt offenders. And to be frank, morals of our citizens declined. Such is the case of human nature when the basics of life are abundant and people look for mundane past-times. Moving away from Judeo-Christian value system is an effect. The cause is boredom.

2008 Sep 17 01:14 PM

[Bazman:]

AIG and the Sleepy American, a story of love

Imagine one day you get an unexpected phone call from your beloved insurance company. “Things are a little tough these days, but our relationships with you are of utmost importance, and we are calling to see how things are going,” they explain. You explain that things were just fine with you, but you don’t recall ever having a good relationship with you friendly caller. As a matter of fact you would classify your relationship over the last several years as problematic. Actually, you would describe it as a relationship where you feel victimized, taken advantage of, and frankly ripped-off.

You recount to your friendly caller the time they wouldn’t insure you because of that pre-existing condition. And the time they increased their quote by 25% because your credit score was below 750. And there was the time they cut your claim by 30% because you forgot to consult with then before it was submitted. Oh, and then there was the time you had to spend two hours a day talking to the claims agent for weeks to get them to pay your claim. And never mind the fact that your premiums have almost tripled in the last 3 years. And there was the time they asked you to leave the relationship because you actually filed a claim. You are finally interrupted by your caller.

“Water under the bridge,” your friendly caller explains. “I really need you to lend me some money. It’s probably more like give me some money, because I’m almost sure I’ll never pay you back. I’m looking for anywhere between $2000 and $2500.” After a few seconds of disbelief, you kindly tell them to kiss your you know what and hang up the phone. Next morning you check your retirement savings account and realize that $2,500 has actually been withdrawn. They did leave you a nice note however. The note says, “Dear friend, sorry to inconvenience you, but based on these extraordinary times of ultra greedy insurance companies, incompetent banks, and sleazy credit card companies, we have decided to commit your hard earned cash to help them out. We know you don’t mind and promise, double promise, hope to die promise to pay you back. We are fully aware of your great sense of confusion and general state of helplessness and have made the wiser choice on your behalf. Lots of love.” Signed, Super smart man Paulson, Genius Bush, and Big Brain Bernake. You shake your head in agreement and go on with your day feeling good about those really smart people making those tough calls, every single day.

2008 Sep 17 04:53 PM

[Jason Rines...:]

That is about the size of it Bazman.


On Sep 17 04:53 PM Bazman wrote:

> AIG and the Sleepy American, a story of love
>
> Imagine one day you get an unexpected phone call from your beloved
> insurance company. “Things are a little tough these days, but our
> relationships with you are of utmost importance, and we are calling
> to see how things are going,” they explain. You explain that things
> were just fine with you, but you don’t recall ever having a good
> relationship with you friendly caller. As a matter of fact you would
> classify your relationship over the last several years as problematic.
> Actually, you would describe it as a relationship where you feel
> victimized, taken advantage of, and frankly ripped-off.
>
> You recount to your friendly caller the time they wouldn’t insure
> you because of that pre-existing condition. And the time they increased
> their quote by 25% because your credit score was below 750. And there
> was the time they cut your claim by 30% because you forgot to consult
> with then before it was submitted. Oh, and then there was the time
> you had to spend two hours a day talking to the claims agent for
> weeks to get them to pay your claim. And never mind the fact that
> your premiums have almost tripled in the last 3 years. And there
> was the time they asked you to leave the relationship because you
> actually filed a claim. You are finally interrupted by your caller.
>
>
> “Water under the bridge,” your friendly caller explains. “I really
> need you to lend me some money. It’s probably more like give me some
> money, because I’m almost sure I’ll never pay you back. I’m looking
> for anywhere between $2000 and $2500.” After a few seconds of disbelief,
> you kindly tell them to kiss your you know what and hang up the phone.
> Next morning you check your retirement savings account and realize
> that $2,500 has actually been withdrawn. They did leave you a nice
> note however. The note says, “Dear friend, sorry to inconvenience
> you, but based on these extraordinary times of ultra greedy insurance
> companies, incompetent banks, and sleazy credit card companies, we
> have decided to commit your hard earned cash to help them out. We
> know you don’t mind and promise, double promise, hope to die promise
> to pay you back. We are fully aware of your great sense of confusion
> and general state of helplessness and have made the wiser choice
> on your behalf. Lots of love.” Signed, Super smart man Paulson, Genius
> Bush, and Big Brain Bernake. You shake your head in agreement and
> go on with your day feeling good about those really smart people
> making those tough calls, every single day.

2008 Sep 19 03:19 PM