Periodically I delude myself into thinking senior Fed officials/PhD economists actually understand how our financial system is designed and is suppose to operate.  Then, I read one of their speeches and I realize they have achieved the impossible and have managed to learn nothing about how the financial system works over the years since the global financial crisis intensified in September 2008.

But why does this surprise me?

It shouldn’t given the Information Matrix was not part of Economics 101 or their PhD program when they went to school.  As a result, they have no idea the financial system is designed to minimize the number of transactions that occur where investors are either blindly betting or there is information asymmetry present.  They have no idea the fundamental building block for the global financial system is disclosure so buyer can know what they are thinking of buying and seller can know what they own and are thinking of selling.

They are also clearly unaware that in exchange for disclosure investors know they must practice caveat emptor (buyer beware) and limit their exposures to what they can afford to lose.  It is this constant assessment of investments and rebalancing their exposures that gives rise to market discipline and financial stability.

Opacity is the necessary condition for a financial crisis as it allows investors to be seduced by Wall Street’s stories and take on more exposure than they can afford to lose.  Of course, when doubt about Wall Street’s stories sets in, the financial markets freeze as was experienced in 2008 and 2009.

Proof of the senior Fed officials and PhD economists don’t get the financial system is based on transparency can be seen in a recent speech by Fed Vice Chairman Stanley Fischer.  In his opening sentence he observes:

In the years since the start of the global financial crisis, an enormous amount of effort has gone into ensuring that we have a robust financial system that promotes responsible risk taking and an efficient allocation of resources.

A quick test of whether this statement is true or not.  Since the global financial crisis occurred along the opacity fault line spreading from opaque structured finance securities to opaque banks, has this opacity been eliminated?

No.

Banks are still black boxes and structured finance securities are even less transparent than before.

So how could investors engage in responsible risk taking and efficiently allocate resources?

Mr. Fischer then goes on to say:

We still lack sufficient information to understand some parts of the shadow banking system, and risks sometimes evolve outside the scope of prudential regulation, with potentially negative implications for financial stability.

Wow.  Almost a decade on from the start of the global financial crisis on August 9, 2007, and the Vice Chairman of the Fed realizes the Fed lacks sufficient information about the risks in the shadow banking system to accurately assess financial stability.

If the Fed doesn’t have the information it needs, why isn’t it leading the charge to bring transparency to the shadow banking system so the information would be available?

The Fed isn’t leading the charge because its senior officials and PhD economists don’t realize opacity is not suppose to exist in the financial system.  If they understood the global financial system was built on transparency, they would call for it in the face of opacity.

Furthermore, if the Fed doesn’t have the information it needs, why would anyone think investors have the information they need to assess risk in either the securities offered through the shadow or regulated banking systems?

Mr. Fischer then offers up:

And sometimes we fail to understand the situation in which we find the financial system and the economy.

In one line, he undermines the rationale for macro prudential regulation.  Underlying this entire concept is the idea it is okay to have the stability of the global financial markets dependent on regulators because they will spot risk and take action to prevent any risk from evolving into a financial crisis.

Here is the Vice Chairman of the Fed saying that isn’t always going to happen.  And when it doesn’t, we end up with another financial crisis.

Let’s go back to how our financial system is designed.  By using the combination of transparency and caveat emptor, the financial system isn’t dependent on any one participant to prevent the next crisis.  Instead, it is dependent on all the investors, including the banks, to prevent the next crisis.

The lesson of our current financial crisis is the SEC was not up to the task of ensuring transparency.  It allowed itself to be captured by Wall Street.  When that happened, Wall Street created so many opaque products that eventually the necessary condition for a financial crisis was put in place.  It was only a question of time before a trigger for the financial crisis appeared.

Going forward, the Transparency Label Initiative is taking on the role of ensuring disclosure so investors can know what they own and limit their exposures to what they can afford to lose.