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The Dirty Little Secret of Finance: Asymmetric Information

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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There’s a very deep, important concept in economics that gets way too little attention from the public (and possibly from economists themselves). This is the idea of asymmetric information. The concept has been around for decades, and research about it has won Nobel prizes, but neither the profession nor the public has ever put it at the center of our understanding of markets . That should change.

When today we debate issues like financial regulation or high frequency trading, it helps to think about financial markets as being driven by differences in how much people know.

The Economist recently ran an article looking back at one of the seminal research papers about asymmetric information -- George Akerlof’s “The Market for Lemons,” published in 1970. That paper showed why it is that when sellers know more about products than buyers do (or vice versa), markets can break down. It doesn’t matter how rational people are, or how well the markets are set up -- asymmetric information throws a wrench in the works.

But it’s in financial markets that this problem might cause the most havoc. For most products, there are things you can do to resolve the information gap -- if you don’t trust a used car salesman about the quality of a car, you can have it checked out by a mechanic. In most markets, reputation is also important.

In finance, however, these tools have often proven to be less reliable than for cars, houses or other products. Taking complicated credit products to a “mechanic” didn’t work in the run-up to the 2008 financial crisis -- the more opaque the product, the more willing the credit rating agencies were to sign off on it. As for reputations, these often simply added to the crisis -- people were probably too willing to enter into contracts with risky banks like Lehman Brothers and Bear Stearns, precisely because of these companies’ sterling reputations.

Why is asymmetric information so crucial to an understanding of financial markets? It’s probably related to the reason people want financial assets in the first place. People want cars and bananas and microwave ovens because those things are immediately useful. But most people who buy and sell financial assets have no intrinsic desire for the asset itself -- they only care about how its value to other people will change in the future. That means that while information is important for many products, when it comes to financial markets, information is the product.

Many major economics papers have explored this fact. One example is the famous 1980 paper “On the Impossibility of Informationally Efficient Markets,” by Sanford Grossman and Joseph Stiglitz. The authors showed that if it costs money (or time) to gather information about financial assets, then market prices can’t be perfectly efficient -- if they were, there would be no incentive for people to go out and pay the costs to gather  data. That paper showed why the famed Efficient Markets Hypothesis can only be approximately true at best.

A 1982 paper by Paul Milgrom and Nancy Stokey is no less important. Entitled “Information, Trade, and Common Knowledge,” it demonstrated why rational financial markets should have a lot less trading than they do. Suppose you come to me offering to sell me a stock for $100 a share. Why are you offering to sell it to me for $100? Maybe you’re selling stocks because you’re shifting into bonds, or ready to retire, or need to pay a sudden medical expense. But chances are, you think the stock is worth less than $100, and you’re trying to unload it. That should make me wary about taking you up on your offer. But on the other hand, if I jump at the offer, that should tell you that I have reason to believe the stock is worth more than $100 … and that should make you wary. In an ideal market filled with rational agents, this means that trading is very rare. The fact that trade volumes are huge is a continuing puzzle for economists, not explained by the classic theories of perfect rationality.

So with all this asymmetric information, why are financial markets so active? A pair of papers in 1985 attempt to explain why. These studies -- the first by Lawrence Glosten and Paul Milgrom, the second by Albert “Pete” Kyle -- model the interaction between informed traders, market makers and liquidity traders. The liquidity traders need to buy or sell immediately for reasons unrelated to the market, but the informed traders are trading because they know something about the asset’s fundamental value. The market-makers -- basically, middlemen -- profit off of the former and lose money to the latter. At the end of the day, this delicate dance gets information out of traders’ heads and into the price. But as some other researchers showed over a decade later, if the information is too complicated, this process can lead to bubbles and crashes.

The upshot of all this -- which will be confirmed by the experience of anyone who has ever traded for real -- is that asymmetric information, which is a nothing more than a nuisance in most markets, is at the core of finance. It’s key to the way traders, including high-frequency traders, make their profits. And it’s probably at the root of why markets break down and crash.

So when someone -- say, a presidential candidate -- proposes big rollbacks of financial regulation, we should be suspicious. In many cases that might be a good idea, but finance is no ordinary market.

  1. An exception to the rule is my colleague Megan McArdle, known to the Twitterverse as @asymmetricinfo.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor responsible for this story:
Tobin Harshaw at tharshaw@bloomberg.net