Thursday, January 1, 2009

Information and economics

Professor Lord Robert Skidelsky is at Warwick and is best known for his 3 volume biography of Keynes. We've referred to him before in a couple of older posts. This article is interesting not only because it presents the basic idea(s) behind asymmetric information, the Akerlof 'lemons' paper and adverse selection in simple terms but also on how it relates the issue of information or lack of it to the current crisis.
Although designed before the current crisis, these models seem to fit current observations rather well: banks lending to entrepreneurs who could never repay, and asset prices changing even if there were no changes in conditions.

But a moment’s thought will show why these models cannot explain today’s general crisis. They rely on someone getting the better of someone else: the better informed gain – at least in the short-term – at the expense of the worse informed. In fact, they are in the nature of swindles. So these models cannot explain a situation in which everyone, or almost everyone, is losing – or, for that matter, winning – at the same time.

The theorists of asymmetric information occupy a deviant branch of mainstream economics. They agree with the mainstream that there is perfect information available somewhere out there, including perfect knowledge about how the different parts of the economy fit together. They differ only in believing that not everyone possesses it. In Akerlof’s example, the problem with selling a used car at an efficient price is not that no one knows how likely it is to break down, but rather that the seller knows perfectly well how likely it is to break down, and the buyer does not.

And yet the true problem is that, in the real world, no one is perfectly informed. Those who have better information try to deceive those who have worse; but they are deceiving themselves that they know more than they do. If only one person were perfectly informed, there could never be a crisis – someone would always make the right calls at the right time. But only God is perfectly informed, and He does not play the stock market.

“The outstanding fact,” John Maynard Keynes wrote in his General Theory of Employment, Interest, and Money , “is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made.” There is no perfect knowledge “out there” about the correct value of assets, because there is no way we can tell what the future will be like.

Rather than dealing with asymmetric information, we are dealing with different degrees of no information. Herd behavior arises, Keynes thought, not from attempts to deceive, but from the fact that, in the face of the unknown, we seek safety in numbers. Economics, in other words, must start from the premise of imperfect rather than perfect knowledge.
It may then get nearer to explaining why we are where we are today.

(Akerlof's nobel prize lecture in pfd form is here; you can watch him deliver it here It is much broader than you may think discussing in a crisp manner issues that have been touched upon in class)

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