An embarrassing moment

This morning while I was reading I remembered a conversation I had with Agnitio in 2004 which, in hindsight, is very embarrassing for me.  It went along the lines of:

Me:  Look at the interest rate on Hanover, its got to be worth putting some money there

Agnitio:  It isn’t that much more than a bank deposit, I’m not sure its worth the risk

Me:  Surely the slightly higher interest rate is a function of only a slight increase in risk

Agnitio:  Not if people don’t understand/are underpricing the risks.

Now, Agnitio was completely right, risks were being underpriced because of asymmetric information.  To make matters worse, people that read the interest rate like I do took it as a signal that the risk was relatively low (although I never did put any money with finance companies, I guess Agnitio must have convinced me 🙂 ) – leading to an “information cascade“.

The current situation has reinforced and extended my belief in the importance of information in the functioning of the market.  I still believe that information asymmetries are the primary factor behind the current crisis.

  • CPW

    Calling it asymmetric is misleading/confusing. It implies that the borrowers had inside information that the lenders didn’t, and were deliberately lying to investors. You need to prove that the investment case was riskier than borrowers made it out to be.

    You could say that there were mistaken beliefs about the distribution of returns, but that is a fairly unsatisfactory explanation of the crisis. Any recession is a result of imperfect information in the sense that ex-post there is investment that wouldn’t have taken place with perfect foresight.

    There are behavioral experiments that show you can get bubbles even with perfect information about returns, too.

  • “It implies that the borrowers had inside information that the lenders didn’t, and were deliberately lying to investors. You need to prove that the investment case was riskier than borrowers made it out to be.”

    True true. However, I thought in the case of the finance companies there was a big uproar because they weren’t providing good sets of financial statements. I agree that, if we experienced a tail outcome and people made losses it is not a case of asymmetric information – however, that was just not the strict impression I had of the situation.

    “There are behavioral experiments that show you can get bubbles even with perfect information about returns, too.”

    There are economic models that show you can get bubbles even with perfect information about returns 🙂

    It doesn’t change the fact that I think it is a matter of asymmetric information.

    However, there are specific “rules of thumb” or “economic structures” that create these bubbles – and I find the assumptions required in these cases more restrictive than the assumption of asymmetric information. However, I am open to having my mind changed 🙂

  • CPW

    I just feel you haven’t provided any examples of where asymmetric information is a problem (especially if we’re talking about the global credit crisis as opposed to NZ finance companies).

  • “I just feel you haven’t provided any examples of where asymmetric information is a problem”

    Fair call.

    I was under the impression that a number of financial institutions did recognise issues with there underlying asset base, and did try to hide it:

    http://www.tvhe.co.nz/2008/10/10/more-evidence-of-asymmetric-information/

    Now, I agree that asymmetric information is not the only issue here – we have “imperfect information” and mis-aligned incentives which have also added to the problem. Furthermore, I agree that they are significant issues.

    However, in the absense of asymmetric information we just have a “bad outcome” – I believe that there must have been an asymmetric information element that lead to a suboptimal allocation of resources as, otherwise, I see no role for government intervention.

    If the problem was just imperfect information, then we should let things slide – as the market will just be reacting optimally to information dissemination.

    If we have asymmetric information then individuals lose trust with institutions, especially when these institutions cannot credibly relate their information advantage back to individuals. In this case, there is a market failure, and government intervention can be supported.

  • CPW

    But three months after Lehman Bros, with financial equity and debt prices way lower, can you still justify the claim that the asymmetric information is the key problem? And its hardly as if the fact that institutions have an incentive to put a brave face on their position is anything new.

    The market failure story you’re telling (if I read you correctly) hinges on there being good institutions that are unable to raise debt because they’re unable to credibly distinguish themselves from bad institutions. I don’t get how this could suddenly produce a major crisis, especially outside of the finance sector where the firm’s financial situation is far more transparent.

  • “But three months after Lehman Bros, with financial equity and debt prices way lower, can you still justify the claim that the asymmetric information is the key problem?”

    Well, trust is the solution to an asymmetric information problem – as long as trust exists we will have a more efficient allocation of resources. The behaviour of Lehman Bro’s was enough to spark up the underlying asymmetric information issue – leading us to a new, pareto inefficient equilibrium.

    “The market failure story you’re telling (if I read you correctly) hinges on there being good institutions that are unable to raise debt because they’re unable to credibly distinguish themselves from bad institutions. I don’t get how this could suddenly produce a major crisis, especially outside of the finance sector where the firm’s financial situation is far more transparent.”

    Note that asymmetric always exists, but the institutions used to help solve the problem have collapsed. This is the key part of the problem.

    If there was some way to reduce the information asymmetry, or for government to prop up institutions, then it prevents us falling into a pareto inefficient equilibrium.

    Now this does not mean that we won’t have a recession – after all a recession may just take us make to a trend level of output. However, an asymmetric information issue is the factor that will cause a market failure, which is something the government might be able to deal with.