Transparency Only the First Step to Fixing Finance

Righting the toppled financial system will take more than transparency.

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Robert Hahn is director of economics at Oxford's Smith School, chief economist at the Legatum Institute, and a senior fellow at the Georgetown Center for Business and Public Policy. Peter Passell is a senior fellow at the Milken Institute in Santa Monica and the editor of its quarterly economic policy journal, The Milken Institute Review. They co-founded Regulation2point0.org, a web portal on economic regulation.

Hernando De Soto, the Peruvian social scientist best known for the insight that shining a light on the underground economy is key to growth in poor countries, writes in the Financial Times that capitalism needs to be "rediscovered." De Soto, like Friedrich Hayek the long-gone Austrian economist who's enjoying a resurgence of popularity these days, suggests that capitalism performs its amazing wealth creation function by being a very efficient purveyor of information about the most valuable uses of scarce resources. Is that ton of steel better used to make toasters or in automobile bodies? Markets have the answer—bureaucrats don't.

[See a collection of political cartoons on the economy.]

In essence, De Soto suggests that capitalism is not so much about money, but about information. It follows that the mortgage bubble and subsequent economic collapse was really due to a breakdown of the mechanism for communicating knowledge about the value and risk properties of assets. Indeed, the core of our current mess, as he sees it, is that the government, the public, and even the private sector, do not have a good handle on how various complex financial instruments, like mortgage-backed-securities and credit default swaps, really work. Worse, few knew how such Rube Goldberg instruments fitted into the scheme of risk apportionment critical to effective asset markets.

For De Soto, then, the fix comes down to rebuilding trust in markets by making it clear to all who owns what—whether it is the house on the hill or the right to collect $14 million from an Indonesian bank if the interest rate on 90-day Treasury bills tops 3 percent in 2014. By his reckoning, parts of the financial system—which is the lifeblood of modern economies—stopped "telling the truth" in 2008. In fact, in some cases the new financial instruments were designed to obfuscate. Think complex swaps, special investment vehicles for burying bank liabilities, and mortgages that weren't recorded properly.

[Read the U.S. News debate: Should the Dodd-Frank Act Be Repealed?]

We agree that greater transparency in the financial sector could certainly help the world economy prosper—but doubt that it is enough. For even if we had easy access to knowledge, the incentives of decision-makers can remain misaligned with those of who suffer or benefit from decisions. Consider the reality that it may make sense for the owners or managers of too-big-to-fail banks to take enormous risks, but it doesn't serve the broader interests of the economy.

De Soto's fix, then, may be necessary, but it is not sufficient. Big economic players, after all, have learned to privatize the profits and socialize the losses. But aligning private incentives with public costs and benefits is easier said than done. The common-sense approach of making sure that banks have more "skin in the game"—to require them to buffer their liabilities with more of their own capital—is being fought bitterly by banks that say it will inhibit their willingness to grease the financial wheels of prosperity.

Not for the first time, De Soto has plucked an invaluable insight from the cacophony of capitalism. We fear, though, that righting the toppled financial system will take more than transparency.

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