In a moment of surprising honesty, Gertjan Vlieghe, a Bank of England monetary policy official, summarized the problems with even the fanciest economic models:
it was impossible for the Bank to forecast a recession, let alone the next crash, and no amount of fine-tuning models of the way the modern economy operates would change that harsh reality.
Appearing before MPs, Vlieghe warned it was inevitable there would be forecasting errors, which could include missing a cataclysmic event such as the 2008 banking crisis.
He said: “We are probably not going to forecast the next financial crisis, or forecast the next recession. Our models are just not that good.”
The impact of this inability to forecast a recession or financial crisis isn’t just limited to monetary policy. It also has implications for the performance of central banks as the regulator in charge of addressing systemic risk.
If central banks cannot forecast a financial crisis, they also cannot manage systemic risk to prevent a financial crisis.
In Transparency Games, I discuss this inability to forecast, let alone prevent, a financial crisis is the primary reason the global financial system is based on transparency. Rather than rely on regulators trying to forecast a financial crisis, the financial system is designed to prevent a crisis occurring in the first place.
How does a transparency based system prevent a financial crisis from occurring?
Every investor knows that in exchange for the information needed to know what they own they are responsible for all losses on their investments.
This is worth repeating. When there is transparency, investors know no one will bail them out of a bad investment.
So they have an incentive to limit their exposure to any investment to what they can afford to lose. The best way to limit their exposure to what they can afford to lose is to use the disclosed data to assess the risk of the investment.
We have over 7 decades of experience showing this ongoing assessment of risk prevents financial crises.
We also have a decade of experience showing when bankers make large segments of the global financial system opaque, we end up with a financial crisis. A financial crisis characterized by investors (and banks should be thought of as investors) having far more exposure to certain classes of investments than they could afford to lose.
Using the Transparency Label Initiative ensures investors they don’t have to rely on central bankers being able to maintain financial stability when even the central bankers admit they are not fit to do so. By limiting their exposures to what they can afford to lose, investors can do the job of maintaining financial stability themselves.