What if it’s all about transparency?

As we launch into the biggest Keynesian stimulus in history, it bears mentioning that its purported efficacy is based on a single historical example, whose success is still debated.

So, as long as we are making unproven assertions about what cures a great depression, here is an alternative. Judge for yourself.

High debt and unknowable exposure don’t mix. You can have one or the other, but not both. If you have low debt, you can tolerate uncertainty about exposure and risk. If you have high debt, you can still take risks, but critically, you need to know exactly where your exposure is, how big it is, or you quickly become insomniac and sensitive to loud noises.

Thus, if you have a debt-driven depression, the first order of business is to massively increase transparency, so that risk can be better quantified by anyone who wants to risk their capital.  Under this model, even bad news would unlock capital, if that news served to quantify exposure.

Repeat:  if you have high debt, unknowns may be OK, but unknowable unknowns are not.

What is a financial panic?  It is the fear of unquantifiable exposure.

“How bad is it right now?” ask investors, consumers and managers. If they can’t answer the question even approximately, then they must assume the worst. When you aggregate those assumptions together, you get a depression.

The obvious policy response is to massively increase the transparency of such exposure. That may bring bad news, but according to Adam Smith (remember him? policymakers sure don’t), individual agents are quite efficient at working around problems, if they know what they are.

This seems to be a forgotten lesson of the Great Depression. “The only thing we have to fear is fear itself.”  What fear? Unknowable unknowns. For example, how safe is your bank?  Are you really getting market price from your broker when you buy a stock? Everyone thought they knew the answers in 1928, but found they could not estimate them even approximately in 1931.

One of the primary policy responses then was to make risks more knowable. For example, consider banking regulation. If a depositor knows his bank must disclose its exposure in great detail to the federal government, his loss exposure is not zero, but it becomes somewhat predictable. Such transparency is much more useful than deposit insurance, because it guides good decisions for both banks and depositors, without moral hazard on either side.

Now investors, managers and consumers are faced again with a sudden tidal wave of unknowable uncertainty.  They thought they knew these basic things, and now realize they know nothing:

  • What is the true default risk of a Moody’s AAA rating?
  • What is the resale value of this or that mortgage-backed security?
  • What is the true financial position of my bank, insurance company or broker?

Throwing money around doesn’t address this problem. No matter what the Fed or Treasury does, the credibility of the credit rating agencies is still suspect. No one knows what certain unregulated securities are worth. Again, high debt is intolerable without transparency.  Until transparency is restored, everyone will still be racing to deleverage, and the ship will keep going down.

Here are some specific actions, which could be taken immediately, that would help restore transparency, permitting all those little rational agents to resume their business:

  1. Create a regulatory agency specifically overseeing credit rating agencies.  Enforce limitations on conflict of interest.  Force one more re-rating of all MBS.
  2. Create a federal mortgage-backed security information website.  Display the contact info of any entity owning more than 10% of a given issue.  Display the deal terms.  Display the actual individual properties held by each mortgage-backed security, scrubbed of personal info, but  still showing 9-digit zip code, square feet, and so on. This would permit anyone to value any MBS, and to contact major owners to make offers.
  3. Several months later (after there has been time to absorb the information), require at least one US exchange to offer a listed market in MBS, displaying bid/ask prices publicly.
  4. Several months later (again, for info absorption time), require all banks and all public companies to disclose their specific MBS holdings.  On the balance sheet, they may either mark to market or hold to maturity, but in any event, must disclose all individual holdings.

The above would drain the swamp in MBS and the rating agencies.  Yes, it would be ugly.  Banks would fail.  But, er, at risk of stating the obvious, if they are holding bad assets, they will fail anyway.

These are the sorts of changes that would bring a true solution.

2 Responses to “What if it’s all about transparency?”

  1. erollins Says:

    See XBRL article “The Road Map for Recovery” in March 2009 Wired (not available on web site yet).

  2. erollins Says: