How Much Would Better Disclosure Help?

In the past, I've tried to explain what I believe the difference is between good regulation and bad regulation. In short, good regulation is that which enhances knowledge and competition, both of which make markets function better. Bad regulation is that which restrains competition and stifles innovation. I've focused a lot on the idea that firms must be able to fail in order for the competition to work. Less government interference also helps to prevent single firm or industry dominance. But I haven't written as much about the knowledge or information aspect. I think that's also very important.

One of the central causes of the financial crisis was a lack of information. Investors didn't know enough about the mortgages backing the securities they purchased. They also didn't have enough information about AIG's ability to back up its credit default swaps. Investors also lacked information about the full extent to which banks were leveraged. Some borrowers lacked information (or at least knowledge) about how their mortgage resets would actually change their monthly payments.

I believe if all parties involved in the different aspects of the crisis had better information, it would all have been a lot less severe. Sure, some would have ignored the information anyway. Others wouldn't have known what to do with it. But some would have used it. If they realized something fishy was going on, they'd tell others, or at least begin hedging the rest of the market, making the impact of the real estate bubble less severe.

There are those who complain about the cost of additional disclosure. To that, I respond: good. Complex financial products should be more costly to sell. Otherwise, you run the risk of developing too complex a financial system, which will result in exactly the kind of crisis we saw. This cost will deter some firms from developing complex or overly-risky products. The additional disclosure will keep others honest in making sure that those who they sell the products to can have all the information about what they're purchasing.

Of course, information and understanding aren't the same thing. You can have all the information in the world, but if you don't have the understanding of how to use it, then it becomes useless. I don't think it's a wonderful idea for the government to get too involved in the business of financial education. At some point, investors and individuals need to accept responsibility for understanding the risk they're taking when buying financial products. But what the government can, and should, do is make sure that those consumers have the available information they need to properly evaluate the products offered.