Handling an asymmetric information problem

Over at the Free exchange blog there is an interesting piece on actions in the current crisis – namely whether to follow the “free market” route or the “inteventionist” route.

My hefty use of speech marks in the above sentence stems from the belief that there aren’t really two distinct schools of thought telling us what to do – there is a single framework of events that forms its descriptive and prescriptive powers from value judgments. These value judgments are thereby the true differences.

This quote sums it up for me:

The problem is that we’ve reached a point of market failure and uncertainty. It’s impossible to tell who the weak banks are.

The difference between the two prescriptions stems from how significant the implied market failure is – not a difference describing what the market failure is.

Those calling for no intervention believe that the weak banks will fail, and the cost of saving the “normally profitable” banks exceeds any benefit – in this case the market failure isn’t big enough.

In another set of value judgments the market has completely broken down. The weak banks will fail – but so will a large number of “normally profitable” banks. In this case the inefficiencies associated with propping up weak banks are dwarfed by the prevention of a market failure.

There are also issues about “what happens later” – can we get rid of the weak banks later, does this policy lead to further inefficiencies down the line? However, the crux of the current disagreement seems to stem from the perceived size of the market failure, stemming from asymmetric information.

The reason that economists have such a wide variation in points of view over this is because the solution to asymmetric information was “institutional” – trust and reputation effects developed to solve the market failure, and now in one foul swoop they have been ripped away.

Without an agreed framework to view these issues, economists have run off in a variety of directions. Now, if only we knew some people that had knowledge about institutional frameworks – then they could apply appropriate value judgments to the initial asymmetric information problem and we could get a good description of what is going on!

  • John

    Ann Ryand seems to think that when all the entrepreneurs go on strike society will collapse. It’s a beautiful idea as it makes a virtue out of greed. I think an analogy is all the actors going on strike: another set of actors would eventually show up. The diversity in society has an evolutionary basis: some of us will just “get on with it” (cooperate) others want to own the whole village (dominate).

    Shouldn’t it be over to banks to prove they are healthy (physician heal thyself)? I’m assuming the bad meat mixed with other meat analogy holds. I think to get confidence back we want to see which banks survive the bad meat and which survive. Market failure will be cured when players realise they aren’t making any money?

  • “I’m assuming the bad meat mixed with other meat analogy holds. I think to get confidence back we want to see which banks survive the bad meat and which survive.”

    That is what the most ardent supporters of free markets would push – however, the existence of asymmetric information makes this type of view a little strong. If there is no way to solve the information problem, then a solution with intervention could be better than a solution without it – however, I definitely wouldn’t use that as a general principle.

    That is why economists have such different views – they hold different value judgments surrounding the extent with which asymmetric information is an important element of market competition.

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