Epistemic Crash
Mark Thoma argues that a major problem impeding the resolution of the financial crisis is
the complete breakdown of traditional information flows, and a loss of confidence in the models used to evaluate that information. Markets need information to work properly, and the information financial markets need is not available.
For example, investors can no longer trust what ratings agencies tell them. A crucial piece of information, information designed to break informational asymmetries between firms and investors, turned out to be unreliable. In addition, investors can no longer believe the numbers they see on bank books. The numbers might say the bank is solvent, but how reliable are those numbers? And even if the numbers are meaningful today, will they be meaningful tomorrow? Is there any way to actually value the assets a lot of these banks have on their books when there is essentially no market for them, no way to engage in price discovery?
The general question of how best to form beliefs based on second-hand testimony, when one has little or no direct evidence, is an extremely difficult problem which admits few good solutions. One of those rare solutions is the market pricing mechanism, which in ordinary circumstances does an astonishingly good job of broadcasting reliable information. These, clearly, are not ordinary circumstances.
Mark Thoma proceeds to suggest various ideas about how to fix the information flows which markets rely upon and how to restore confidence in their accuracy. That is, he offers advice on how to help the market return to ordinary circumstances. The greater challenge is to understand how and why the market became so epistemically dysfunctional in the first place. Presently, there is no consensus among economists as to the root cause of even relatively simple cases of epistemic dysfunction in the markets, such as assest price bubbles. (In the current crisis, the bubble in house prices has lead to a much bigger and more complicated mess.) It is difficult to devise means to prevent future financial crises when such basic questions about their causes remain unanswered.
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