Sun, Dec 28, 2008 - Page 9 News List

Perfectly imperfect

So much knowledge in economics is predicated on informed decision-making.The global financial crisis reminds us that this was never a sound foundation

By Robert Skidelsky

Economics, it seems, has very little to tell us about the current economic crisis. Indeed, no less a figure than former US Federal Reserve chairman Alan Greenspan recently confessed that his entire “intellectual edifice” had been “demolished” by recent events.

Scratch around the rubble, however, and one can come up with useful fragments. One of them is called “asymmetric information.” This means that some people know more about some things than other people. Not a very startling insight, perhaps. But apply it to buyers and sellers. Suppose the seller of a product knows more about its quality than the buyer does, or vice versa. Interesting things happen — so interesting that the inventors of this idea received Nobel Prizes in economics.

In 1970, George Akerlof published a famous paper called “The Market for Lemons.” His main example was a used-car market. The buyer doesn’t know whether what is being offered is a good car or a “lemon.” His best guess is that it is a car of average quality, for which he will pay only the average price. Because the owner won’t be able to get a good price for a good car, he won’t place good cars on the market. So the average quality of used cars offered for sale will go down. The lemons squeeze out the oranges.

Another well-known example concerns insurance. This time it is the buyer who knows more than the seller, since the buyer knows his risk behavior, physical health and so on. The insurer faces “adverse selection” because he cannot distinguish between good and bad risks. He therefore sets an average premium too high for healthy contributors and too low for unhealthy ones. This will drive out the healthy contributors, saddling the insurer with a portfolio of bad risks — the quick road to bankruptcy.

There are various ways to “equalize” the information available — for example, warranties for used cars and medical certificates for insurance. But since these devices cost money, asymmetric information always leads to worse results than would otherwise occur.

All of this is relevant to financial markets because the “efficient market hypothesis” — the dominant paradigm in finance — assumes that everyone has perfect information and therefore that all prices express the real value of goods for sale.

But any finance professional will tell you that some know more than others, and that these people earn more, too. Information is king. But just as in used-car and insurance markets, asymmetric information in finance leads to trouble.

A typical “adverse selection” problem arises when banks can’t tell the difference between a good and bad investment — a situation analogous to the insurance market. The borrower knows the risk is high, but tells the lender it is low. The lender who can’t judge the risk goes for investments that promise higher yields. This particular model predicts that banks will over-invest in high-risk, high-yield projects, that is, asymmetric information lets toxic loans onto the credit market. Other models use principal/agent behavior to explain “momentum” (herd behavior) in financial markets.

Although designed before the current crisis, these models seem to fit current observations rather well: banks lending to entrepreneurs who could never repay, and asset prices changing even if there were no change in conditions.

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