Ignorance is bliss

Yesterday I read through a fascinating paper called Opacity and the Optimality of Debt for Liquidity Provision. The main point is that welfare of participants is maximized when using debt instruments to trade, rather than, say equity or real assets. The reason is that participants will be less worried about a debt than by a piece of equity, so they will seek less information, which in turn will maximize the issuance of debt, and maximize welfare.

Of course, while all of this is fine, a serious financial crisis can happen when everyone starts doubting at once about the debt that no-one seemed to question at all.

What’s fascinating is that according to the authors: welfare is maximized when participants are equally ignorant of the actual quality of the debt and trade simply according to its face value:

In this economy government policies that increase transparency would reduce welfare. This would seem to be counter to the intuition built from the idea of efficient markets.

They do not stop there. They actually claim that the complexity of securitization, CDOs, etc. is good because it increases costs about figuring out the exact value, which in turns maximizes welfare because it facilitates trade as long as everyone is equally unwilling to do any homework (if I understand correctly):

Clearly, if complexity raises the cost of producing information, raises ?, this can be welfare improving. Suppose that agent A could choose a level of complexity for the security designed at t=1. This corresponds to choosing some ? less than a given maximum. For large w, agent A would always choose to issue the most complex security, the one with the maximum ? because this maximizes the amount of debt that will be accepted by agent B without triggering information production.

More, they even justify one of the roles of the central bank as maintaining the opacity and secrecy.

The lender-of-last- resort’s role is to exchange information-insensitive debt for information-sensitive debt, possibly at a subsidized price to prevent information production, or, to make the private debt, which has become information-sensitive, information-insensitive. This prevents the crisis from being worse…

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