Guest Column: Robert Skidelsky

Published on Tuesday 6 January 2009 20:49

ECONOMICS, it seems, has very little to tell us about the economic crisis. Indeed, no less a figure than the former United States Federal Reserve chairman, Alan Greenspan, recently confessed that his entire "intellectual edifice" had been "demolished" by recent events.

Scratch around the rubble, however, and one can come up with useful fragments. One of them is called "asymmetric information". This means that some people know more about some things than other people. Not a very startling insight, perhaps. But apply it to buyers and sellers. Suppose the seller of a product knows more about its quality than the buyer does, or vice versa. Interesting things happen – so interesting, that the inventors of this idea received Nobel prizes in economics.

In 1970, George Akerlof published a famous paper called The Market for Lemons. His main example was a used-car market. The buyer doesn't know whether what is being offered is a good car or a "lemon". His best guess is that it is a car of average quality, for which he will pay only the average price. Because the owner won't be able to get a good price for a good car, he won't place good cars on the market. So the average quality of used cars offered for sale will go down. The lemons squeeze out the oranges.

All of this is relevant to financial markets because the "efficient market hypothesis" – the dominant paradigm in finance – assumes that everyone has perfect information, and therefore that all prices express the real value of goods for sale. But any finance professional will tell you that some know more than others, and they earn more, too. Information is king. But just as in used-car and insurance markets, asymmetric information in finance leads to trouble.

A typical "adverse selection" problem arises when banks can't tell the difference between a good and bad investment. The borrower knows the risk is high, but tells the lender it is low. The lender who can't judge the risk goes for investments that promise higher yields. This particular model predicts that banks will over-invest in high-risk, high-yield projects; ie, asymmetric information lets toxic loans on to the credit market.

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 at the same time.

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.

Rather than dealing with asymmetric information, we are dealing with different degrees of no information. Herd behaviour 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.

&#149 Lord Skidelsky is professor emeritus of political economy at Warwick University.