With the stock market nosediving, credit lines freezing, retirement savings disappearing overnight, and the state budget on the chopping block, we are facing an economic peril as great as any since the Great Depression. What are we to make of these frightening times? We asked some leading voices in the world of economics, political science, and public policy to help make sense of the tumult we find ourselves in. See all of them here. Below, economist David Weil:
A recurring refrain of those discussing the way forward from the current economic crisis is the call for more transparency. After Congressional passage of the Emergency Economic Stabilization Act on October 2, for example, Treasury Secretary Henry Paulson stated, “Transparency throughout this process will be important, and I look forward to providing regular updates as we move ahead to implement this strategy.”
The value of transparency, like motherhood and apple pie, is easy to invoke. Yet the meaning of transparency can be elusive, particularly when applied to a crisis of the complexity and scale of the current one. I offer a few comments on where and how transparency may be useful in the short, medium, and long term.
The turbulence of the stock market in the days since passage of the “Bailout Bill” by Congress derives in part from the hour-by-hour (or minute-by-minute) effort by investors to read the tea leaves on whether or not markets have hit the bottom. Emotions are driving behavior because we are in such uncharted waters. Explanatory transparency can play an important role in the short term in moderating emotions. In particular, we need greater transparency by Secretary Paulson, Federal Research Chairman Bernanke and other key public leaders in explaining to investors and the wider public how the various means that have been created to deal with the capital crisis actually work, thereby setting clearer expectations about how long they will take to implement and have their intended effects.
The unrealistic notion among many that passage of the initial legislation or the agreement between the Treasury, Federal Reserve, FDIC, and banks on injecting capital would instantaneously lead to a “solution” to the crisis added fuel to recent turbulence. It is essential that Paulson and others provide a clearer roadmap by laying out what is to be done and how it will likely play out in the capital markets and ultimately the real economy.
Second, in the medium term, we need to rebuild trust in public and private institutions by expanding procedural transparency. Deep recessions arise in part from collapsing expectations about the economy and the future. Rebuilding faith in our future requires addressing the deep distrust that has grown during the Bush administration about the way that decisions are made in both public and private spheres. Coming out of this crisis requires restoring confidence that leaders of major institutions will make defensible decisions guided by the larger public good. The secretive nature of decision-making in the Bush administration and its record of distorting information in foreign and domestic policymaking to serve its narrow interests have been corrosive. Providing the public with greater insight into how and why decisions are being made to deal with the economic crisis will be crucial to repairing frayed public confidence.
Finally, in the long term, we need to rebuild the regulatory transparency systems that provide information in key parts of the financial sector. This must begin with revising both who provides information to potential mortgagees and the type of disclosure documents they receive. No system of transparency can work if the purveyors of information have incentives to obfuscate. It should not be a surprise that mortgage brokers and other lenders who bore little if any of the risk of loan defaults assured potential borrowers that disclosure documents regarding the costs and risks of their mortgages were irrelevant, complex, and legalistic paper exercises. Making sure that part of the mortgage risk is borne by lenders will better align the incentives for truthful disclosure. But that alone is not sufficient: we must also change the way that information is conveyed to the millions of people who will once again seek to borrow when the crisis begins to subside, and ensure that it is conveyed in formats and language that people can truly understand and weigh.
We also will need to rebuild transparency in the wider investment markets. Once again, this requires changing basic incentive relationships between those who convey information, those who rate securities, and those who use that information so that the parties who appraise investments receive no direct financial benefit from the ratings they assign to them. And we need to rethink how we convey that information to conform to the principle often ascribed to Warren Buffett: Never invest in something that you don’t understand. It seems clear now that very few of the people who bought and sold sophisticated derivatives actually understood how they worked, much less the risk associated with them. Future capital markets will continue to employ complicated financial instruments to allocate risk. Those capital markets will need new mechanisms to translate those risks into comprehensible formats.
The road back to a healthy economy will be a long and difficult one. Rebuilding trust through explanatory, procedural, and regulatory transparency policies will be an important element in finding our way forward.
David Weil is professor of economics and Everett W. Lord Distinguished Faculty Scholar at Boston University School of Management and co-director, with Archon Fung and Mary Graham, of the Transparency Policy Project at Harvard’s Kennedy School of Government.