In my free-market meanderings, I run into plenty of resistance about the role of free markets and those who would see government addressing supposed market failures. One of the critiques of markets that is the most potent, even for a free market defender such as myself, is the problem of “information asymmetry,” or the idea that market actors do not always have the requisite information to make good decisions. Whether the reason is malfeasance of a big company (hiding information from buyers about the dangers of their products or services) or the complexity of market interactions and the inability to see the future, it is plainly true to all of us that buy goods and services where we will not know the full implications of the product or service we are buying up front. This problem becomes increasingly more complicated in financial markets, where lies, omissions, or innocent negligences can lead to problems that exacerbate the sphere of damage done to the consumer.
Many argue that the (only) solution to this problem is the government – that the power of law should be used to require a certain degree of disclosure on all products and services, including severe punishments for omissions that harm consumers. Consumer legislation is easily enough refuted, because it is often true that the regulations themselves cause more harm than good. A great lecture on the matter can be found here. When it comes to financial markets, on the other hand, it is harder to see why regulations are inefficient at banishing information asymmetry in any meaningful way. (And of course, even if granted that the protective disclosure laws are a good idea, they are at best only a partial solution – since many disclosures have to do with the complexities of market interactions and an inability to see the future, risk can never be completely eliminated.)
Even more persuasive than the pleadings above is the fact that information asymmetry does not disappear when government steps in. In fact, it increases, for two reasons. The first is an assumption that the government is doing its job, which gives a false sense of security to the consumer engaging in the market without having done his research. This means that the due diligence, caveat emptor mindset that is (or should be) naturally a part of a consumer’s choices is absent. The second is that the average citizen voter is not privy to the information that governments use to make their economic decisions, which in the case of public policy increases information asymmetry across the board. Information asymmetry is exacerbated severely because the public does not have incentive to learn about an area of the economy which the government dominates – and even if they could, the citizens could not alter the course of action that the government has taken. Instead of a citizen buying a product/service and being harmed by it which would result in some financial or personal harm to him, the government decides on a course of action which spreads over society, harming a greater number of people. That principle, public choice theory, is a branch of economics that developed in the 60s and 70s that is widely ignored while being nearly fully intellectually intact to this day. According to public choice theory, consumers are not always rational actors in the marketplace. This occasionally results in monetary or physical harm to the consumer – for a failure to see the “side-effects” of a product or service as a result of information asymmetry. Even though the harm occurs and harm is obviously a bad thing, the harm is limited to the actor engaging in the action in the marketplace. This is in steep contrast to the economic actions of a government, which bind many hundreds, thousands, or even millions of people. Given that politicians and technocrats are still market actors who must make decisions about economic action without all information pertaining to the transaction (since we cannot see the future, of course), mistakes of the same type occur as if the politician/technocrat was a solo economic actor. The difference in this circumstance is that the economic decision is enshrined in law, which leads to the poor economic choice being forced upon more people, and the harm increasing significantly overall.
I was asked the other day how consumers could protect themselves from market asymmetry in a free market, and this was my response, which is one idea that took a very limited amount of time to generate:
One way I think it could be solved with a sort of insurance, one that is similar to title insurance or certain derivatives. For the risk that I incur in buying into this venture, I would like to insure against any fraud or omissions. Notice this isn’t insurance against loss altogether (in contrast to many derivatives). It is just insurance against malfeasance. An honest and proportional derivatives/insurance industry could arise based on this premise. Frankly, it should already exist, and maybe it does (you would know more about this than I would). I am sure that the SEC makes people think that it is redundant, though. That is one example. I am not extremely creative, but if you’d like I can come up with others. I am not sure that a monopoly of force is the single answer to the problem of informational asymmetry. In the consumer goods markets, the answer is a private firm called Underwriters Laboratories. Check it out sometime if you have a moment.
I also think that investment in stocks in general is an inflated market, and one that shouldn’t be as stressed as it is today by modern financial gurus. Many, many debt instruments and hedges would not exist in the absence of the laws, regulations, and government insertion into the market that we see today that allow for such things. Those instruments that exist because of monetized debt tend to be some of the highest yielding, as well as the most risky – generally because they are government-backed. I am sure you can see further reasons why. On the free market, firms would be much less likely to be highly leveraged. This includes fractional reserve banking, and many types of investment banking. The abolition of the legal monetization of debt creates risks that would cut the problem of asymmetrical information down by 90% – and the rich guys who are betting vast amounts of money would be the losers, as opposed to the socialization of losses that we see today due to the government insurance and currency devaluation created by such leveraging schemes…
Yes, public share issuance is a good way for a company to capitalize amongst many people. But it is also a good way to skew investment in a way that many firms cannot handle, or mismanage. In short, it can be a good way to dupe lots of people. I really would be uncomfortable investing in any company without seeing their financial strength – but the average stockholder just looks at the newspaper or sees a trend and calls his broker to buy, buy, buy. The SEC cannot protect the ignorant investor, no matter how many rules they pass. Nor can any body seeking to rid the world of asymmetrical information.
Of course fully secure and risk-free existence is never possible, though we may think that the government’s edicts may eliminate some of them. Even so, public choice theory shows that the correct answer to economic action and elimination of risk to consumers is not the government. With that, I leave you with Bob Murphy speaking about the public’s demands for security, and why it will not likely come from the state until we have reached a totalitarian “paradise” – the cry for security.