Monday, July 9, 2012

Bank of England's Paul Tucker discovers opaque markets are not to be trusted

In his testimony before the Treasury Select Committee, Bank of England deputy governor Paul Tucker revealed that he was unaware that opaque markets are not to be trusted.

[Mr. Tucker] said, he had not been aware until recently that Barclays was a "cess pit" of rate manipulation. 
"What has been revealed has come as a deep shock, a deep shock," he added. 
"We thought it was a malfunctioning market not a dishonest market. 
With this explanation, Mr. Tucker explains why the economic profession did not see the financial crisis coming.  The issue of transparency/opacity was nowhere to be seen.

It took Barclays paying almost $500 million in fines to bring the attention of the economic profession to the simple fact that by design the calculation of the Libor interest rate is opaque.

It took Barclays confessing to manipulating the Libor interest rate to show that opacity hides bad behavior.

Why do I keep saying the entire economic profession missed seeing the financial crisis when there were  a couple of economists at the BIS who warned about the problems with subprime mortgage securities?

Because rather than adopt their warning, the economics profession dismissed it (I am missing the link to Bill White's speech in which he discusses being dismissed).  What was clear from this dismissal was that their prediction was not based on widely accepted economic theory, but rather their analysis of the situation.  If it had been driven by economic theory, it would have been far harder to dismiss by the economics profession.

As a result, it is highly unlikely that in the future they could repeat this success or that they necessarily had any insight into what steps needed to be taken to end the financial crisis.  The latter has been confirmed by what they have written and said since the crisis began as only recently has the BIS begun to support the idea that banks have to recognize the losses currently hidden on their balance sheets.

By way of comparison, I too also predicted the financial crisis.

Regular readers know that the prediction was based on the FDR Framework.  Specifically, that the failure of financial regulators to ensure transparency provided bankers with the opportunity to engage in bad behavior behind the cloak of opacity.

Please note, the FDR Framework happens to be based at the very heart of economic theory.  Specifically, it is based on the one necessary condition for the invisible hand to operate properly.

The necessary condition is that there is transparency so the buyers knows what they are buying.  This means that the buyer has to have access to all useful, relevant information in an appropriate, timely manner so they can make a fully informed investment decision.  

I say it is the one necessary condition because everything else is a market inefficiency.  Included in inefficiencies for example is the seller is a monopolist.

Unlike the BIS prediction, my prediction had very explicit steps that need to be taken to fix the financial system and avoid future crises.

For example, due to the Nobel prize winning work of Joseph Stiglitz, we know that opaque markets are not to be trusted.  As he pointed out, opacity hides information asymmetry and the party with better information has an incentive to take advantage of the party with worse information.

Once the party with worse information realizes they have been taken advantage of, they exit the market until there is transparency that eliminates the information asymmetry.

The FDR Framework captures this by making it the responsibility of the government to ensure that market participants always have transparency.

Now that the Bank of England has found that markets like Libor and structured finance are not malfunctioning, but dishonest, it is time we take the first step and address the underlying opacity in the market.

I look forward to hearing from the Bank of England and advising them on how to remove opacity from every corner of the UK financial system.

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