Sunday, March 31, 2013

Disclosure: a Weak Underbelly of the Interventionist Economy

My friend Marc Joffe, a financial analyst and expert on public sector credit rating, says that there are four fields in which “capitalism” has a “weak underbelly.” These are appraisal, auditing, equity research, and credit ratings.

I have a semantic quibble about the term “capitalism,” as it seems here to be applied as a label for the current economies of the world, but the implication is also that the term applies to a pure market economy. The relevant economic issue is whether these really are four free-market horses of financial trouble if not apocalypse.

As stated by Joffe in his Progress Report article, “The Weak Underbelly of Capitalism” (, these four fields of financial analysis “inform investors about the value and risk” of assets. When people buy property based on incorrect valuations, these can become bad investments and speculations that, if systemic, can either contribute to asset bubbles or else hamper growth. Austrian-school economists call these “malinvestments” and “malspeculations.”

Indeed, there is plenty of evidence that financial-analytic services have been faulty. There were bad analyses of firms such as Enron, the 1990s Internet firms, and the credit ratings of mortgage derivatives during the real estate boom that crashed in 2008.

Joffe says that the analysts can be “bullied or bribed” by the chiefs of their firms or by clients “to distort their findings.” Some analysis can go awry from using biased assumptions that turn out to be incorrect, but misconduct could also be deliberate fraud that enables sellers to steal from misled buyers. A morally proper contract must encompass parties who are truthfully informed.

In a pure free market economy, all transactions are voluntary. Theft, including fraud, are violations of property rights. Fraud is outside the market, and the free market included the protection of property rights, hence the prohibition and punishment of fraud.

What is deficient is therefore not the market, but the law and its enforcement. The failure to prevent such deliberately misleading financial data is a government failure. To say that it is a problem of “capitalism” is confusing, because “capitalism” could refer to today’s mixed economies, markets distorted by intervening restrictions, taxes, and subsidies.

However, as Marc Joffe states, the governmental regulation of financial analysis is inherently deficient. It would be too costly for regulators to oversee every appraisal, audit, valuation, and credit rating. Moreover, a regulatory agency would also be vulnerable to capture by the financial industry, i.e. the members of the agency would come from the financial fields and could be bribed by special favors that are on the edge of legality. It could be difficult to distinguish between an honest mistake and a deliberate failure to correct dishonest data. We have witnessed Ponzi schemes such as the Madoff scandal that the SEC (Securities and Exchange Commission) failed to prevent or stop.

Joffe offers a solution in greater disclosure. When information is made public, more people can review the data and catch errors. Peer review can also promote the best methods of analysis, such as with open-source projects. Joffe’s solution is therefore a four-horse open carriage, making the analyses of appraisal, auditing, equity research, and credit ratings available to the public. To help achieve that goal for ratings, Joffe has developed an “open source government bond rating model.”

The economic question is then whether the governmental requirement of disclosure for financial analysis used in transactions is an intervention into the market, or else whether such disclosure is market-enhancing and therefore not an intervention but actually part of the market as a protection of property rights. In ethical terms, is there coercive harm to others when there is no disclosure?

As stated by Joffe, financial firms enhance their profits “by keeping information to themselves.” Therefore a mandatory full-monty disclosure reduces their economic profit, i.e. profit beyond normal returns to labor and asset values. Firms can charge more for evaluations and ratings when the information is not available to others.

On a pure cost-benefit basis, disclosure would surely have a much greater economic benefit than the cost of lost profits. But free-market policy analysis must be based on the ethic of the market, not merely on cost-benefit, since a pure utilitarian view would trample on enslaved minorities if there were greater total benefits to the majority.

The free-market answer is meta-disclosure at the highest level of choice. A meta-disclosure is disclosure about disclosure. For example, rather than either allowing or forbidding insider trading, a firm would be required to disclose in its corporate charter the extent to which its officers may engage in insider trading. Then the shareholders would make their decisions accordingly.

What government should do is require meta-disclosure for all financial firms. A firm doing appraisals, audits, or ratings would be required to state in its charter whether it makes its findings public. If the accounting firm says that its audit methods and results are not public, then if a corporation board chooses to be audited by that firm, the shareholders and lenders would be warned to be skeptical about an audit that claims that the company accounts are proper. If an appraisal firm says its findings are not public, then a buyer would be wise to doubt the truthfulness of the valuation. Market participants would discount non-disclosed products.

Meta-disclosure is not an intervention, because it enables property rights to be clearer and better protected. A pure market is not a case of “anything goes.” Contracts among ill-informed parties are not morally proper. Therefore Joffe is basically correct in advocating disclosure, but in my judgment a meta-disclosure requirement is sufficient. The weakness is therefore not of the market as such but of the failure by government to have a basic “law of the market” requiring meta-disclosures not just by firms but also for products.


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