Institute for Financial Transparency

Shining a light on the opaque corners of finance


Stanley Fischer’s Last Great Economics Lesson

With the announcement of his retirement as Fed Vice Chairman, I thought it would be interesting to browse through a few recent speeches by the man who taught economics to Ben Bernanke, Mario Draghi, Larry Summers (ok, he audited the course) and a host of others.

What I found was an individual who embodies the pervasive lack of understanding of how our global financial system is designed shown by the Economics profession as a whole.

As regular readers know, the Information Matrix explains both why our financial system is designed as it is and where financial crises come from.  In short, our financial system is designed to push everyone to invest where they can know what they own and away from where they blindly bet on opaque securities.  This design reflects the fact financial crises occur in the areas of the financial system where people are blindly betting.

These insights from the Information Matrix are absent from Mr. Fischer’s speeches.

Instead, we are left with a man trying to justify the financial reforms put in place since 2008.  Reforms he would like you to believe will work.

But why should anyone believe these reforms will work given the Fed and the rest of the Economics profession has still not been able to answer the Queen’s Question of why they didn’t see the financial crisis coming?  They shouldn’t.

In Mr. Fischer’s telling of the financial crisis:

Although there were many dimensions to the financial crisis, the poor performance of subprime mortgages was one of the triggers. The fact that losses in what was a relatively small part of the mortgage market quickly spread through the rest of the financial system illustrates how the complex interconnections among banks and nonbanks can amplify shocks in significant and unanticipated ways.

Some of the first cracks in the nonbank sector appeared in April 2007, when New Century Financial Corporation, at one point the second-biggest subprime mortgage lender, filed for bankruptcy after its creditors pulled back on fears about its losses.

This description completes misses the financial crisis occurred along the opacity fault line in the global financial system.

He even observes creditors refused to fund New Century Financial Corporation due to “fears about its losses”.  Refusing to fund is what investors due when doubt or fear creeps in about the value of an opaque investment.  They run to get their money back.  Of course, had there been transparency, creditors would have known what the true condition of NCFC was.

There was nothing unanticipated about the ways the crisis spread.  It moved from one opaque portion of the financial system to the next.  The opaque investment banks were next.  Nobody knew the extent of their exposure to subprime securities.  After that came the opaque commercial banks and their unknown exposure to subprime securities.

By missing the role of opacity, Mr. Fischer is left to make the case regulation and regulatory enforcement will work better than transparency and market discipline.  Unfortunately, this case isn’t believable because the Fed failed as a regulator in the run-up to the financial crisis.  Not only did the Fed assert the subprime losses were contained, but almost all of the Too Big to Fail banks it supervised were insolvent in late 2008.  Not exactly the track record that inspires confidence regulators will do better.