Credibility, Failure of Disclosure, Financial Crisis

I was thinking about the question I raised last time: what happens if no one knows anything but investors have crazy belief that some one (e.g. large financial institutions) must know something?  And I am wondering whether it be one suspecter of the financial crisis?

Information theory shows us that disclosure may mitigate the information asymmetry problem and improve efficiency.  However, an embedded assumption is that the disclosure is credible.  What if no one or some one just does not believe what have been disclosed?  It could be that the firm who makes the disclosure is indeed a trouble firm and gives faked information and/or the regulation is not under-developed and could not detect it for the investors.  Or it could also be that the investors can neither believe the firm or the regulator due to their dirty history.  In this case, disclosure is nothing good but a waste of money because it is usually costly.  As a result, disclosure destroys value ex-post, although, ex-ante, firms disclose in the hope of improving efficiency.

I suspect that this situation happened in the recent financial crisis, at least to some level.  The government thought they are doing their job, to force mandatory disclosure and to encourage voluntary disclosure, so that market is becoming more efficient.  But some investors do not believe those any more, because there were too many scandals in the history: Enron, Worldcom, ...... Now even government can default: Iceland, and Greece almost...... Then what?  It is difficult to tell who is telling the truth nowadays, and disclosure could sometimes fail.  The failure of disclosure could bring even bigger disaster than information asymmetry itself because the firms and the government may not be aware of the possibility of the failure of disclosure and disclosure is itself costly.

The worst thing is not that you find a weakness of yours because you can then do something to improve it, is that you have a weakness but you just do not know it or do not want to admit it, yet.

I thought you would know...

The effect of information asymmetry in economics attracts more and more attention since the 1960s.  Joseph Stiglitz, Micheal Spence and George Akerlof were awarded the Nobel prize for their theories on this topic.  Information asymmetry is no doubt a very important problem in economics and finance.  


However, there could be more than one type of information asymmetry.  In the stock market, for example, the manager of a public company may know more about the stock value than the investors.  At the same time, institutional investors could have more information than an individual investor.  What is more, the broker dealer may have inside information either through his network or through his inventory information.


There have been theory models and empirical tests that address each type of information problem respectively and suggest ways to mitigate them.  But what happen if they exist simultaneously and interact with each other?  Even worse, what if we assume someone else has private information yet in fact no one knows anything at all?  If we also take this case into consideration, will the prediction change dramatically?  Will it lead to a tremendous aggregate effect, just like the butterfly effect, and bring some unexpected change to the stock market?


I do not have an answer yet, but I think it could be an interesting question.  When I talk to people who trade stocks, they usually complain that the market makers and institutional investors have so much inside information that they take away a lot of money from the stock market.  Let us leave alone whether such statement could be true and focus on this belief itself.  


If it is true that some investors believe they are trading against insiders, should we focus more on this information disadvantage than the fundamental value of a stock?  Could it be the reason why sometimes stock price deviates a lot from its fundamental value?  In this "crazy" situation, what matters most is people's belief.  For example, we sometimes see news says "the market is panic".  It could be the case when individual investors all believe that the big traders have inside information while the truth is no one knows anything.

If this false belief is a price factor, it could be somewhat related to investor overconfidence/underconfidence or investor sentiment.  But it is still different because it could be augmented or cancelled in aggregation and it is not at all clear ex-ante in which direction it could affect the price.  And because the belief itself is false, it could also create inefficiency and destroy social welfare.  In addition, information disclosure does not help in this case because people simply do not believe whatever you disclose to them.  Sometimes disclosure could even be thought of as a bad signal that the firm tries to cover or mislead something.