Thursday, May 12, 2011

Financial transparency isn't enough

It was good to hear Obama today continuing to fight (well, OK, it's the Obama version of "fighting," which isn't likely to leave any lasting marks) for financial reform. He noted that greater transparency of financial transactions might have prevented the meltdown.

Well, transparency is a very worthy goal, but it isn't enough. I've just read Ha-Joon Chang's 23 Things They Don't Tell You About Capitalism (recommended), and he makes this point very strongly (Chang is the Oxford economics professor well known for pointing out the hypocrisy of rich countries who lecture developing countries about the need to "open their markets.")

Chang's argument is simply this: even if we had perfect transparency, today's financial markets are just far too complicated for any person—even the economist's mythical "rational man"—to fully understand and deal with. This was dramatically illustrated by the meltdown, when it became obvious that even the top executives of financial firms had only the dimmest understanding of the hypercomplex investments their underlings were trading by the hundreds of billions.

As Chang says, the only hope we have of dealing with this complexity is to make simplifying assumptions: to "deliberately restrict our freedom of choice in order to reduce the complexity of problems we have to face."

This leads directly to the money quote:

Often, government regulation works, especially in complex areas like the modern financial market, not because the government has superior knowledge but because it restricts choices and thus the complexity of the problems at hand, thereby reducing the possibility that things may go wrong.

An example: it was a choice of the banksters to operate with 30X leverage. Given their confidence that they were too big to fail, you could even argue that it was a rational choice (further encouraged, let's admit, by the irrational glory of being the baddest gunslinger in town). Had the government regulators simply restricted this choice (and perhaps a few other similarly irresponsible ones), we wouldn't have had to do the hated bailouts or cope with the Great Recession.

And one final key point: even if you grant the free marketeers that an unregulated market works best for that market, there is obviously no guarantee that what's best for that market is best for the society as a whole.

Free marketeers argue that government regulation can only gum things up, since the gummint can't possibly know the workings of the market as well as the players in it. Chang's point is that sometimes that's a good thing.

So: transparency, yes. But watchful regulation too.