The Great Financial Crisis should have been a great opportunity for the Economics profession. Not only to engage in a review of how it missed seeing the crisis coming, but also to examine why it supported a series of responses that made the crisis far worse for the real economy than it had to be.
Fortunately, Paul Krugman provided a blog post describing in detail why the opportunity was missed.
When the financial crisis struck, there were many calls for new economic ideas – even an Institute for New Economic Thinking. The implicit story, pretty much taken for granted as true, was that the crisis proved the inadequacy of economic orthodoxy and the need for fundamental new concepts. Pretty obviously, too, supporters of calls for new thinking had a sort of Hollywood script version of how it would play out: daring innovators would propose radical ideas, would face resistance from old fuddy-duddies, but would eventually win out through their superior ability to predict events.
What actually happened was very different. True, nobody saw the crisis coming. But that wasn’t because orthodoxy had no room for such a thing – on the contrary, panics and bank runs are an old topic, discussed in every principles book. The reason nobody saw this coming was an empirical failure – few realized that the rise of shadow banking had done an end run around Depression-era bank safeguards.
The point was that only the dimmest of free-market ideologues reacted with utter bewilderment. The rest of us slapped our foreheads and said, “Diamond-Dybvig! How stupid of me! Diamond-Dybvig!”
Let’s start with Professor Krugman’s script.
Frankly, the Information Matrix below is a radical idea. Imagine the chutzpah of developing a Matrix that explains the design of our financial system, the source of financial crises or why there are bank runs.
|Does Seller Know What They Are Selling?|
|Does Buyer Know What They are Buying?||Yes||No|
|Yes||Perfect Information||Antique Dealer Problem|
|No||Lemon Problem||Blind Betting|
The Matrix and I have received plenty of resistance from old buddy-duddies in the Economics profession. Some have tried to argue the Blind Betting quadrant doesn’t exist, but is rather another example of information asymmetry. To them I point out the Bank of England’s Andy Haldane refers to banks as black boxes, but that doesn’t stop their stocks from trading.
Others have instead tried to dismiss the Matrix by focusing on my lack of an Economics PhD. To them I would just point out: Adam Smith didn’t have an Econ PhD, but all of Economics is based on an idea of his; Walter Bagehot didn’t have an Econ PhD, but modern central banking is based on an idea of his; and John Keynes didn’t have an Econ PhD, but how we think governments should respond to a recession or financial crisis is heavily influenced by an idea of his.
Last in his script was the radical idea winning out through its superior ability to predict events. Amazingly, the Matrix has continued to outperformed all other ideas, like Informationally Insensitive Debt, that have been championed by the Economics profession.
So a decade on from the start of the financial crisis, the Information Matrix is still waiting for the end of Professor Krugman’s script where it is embraced by the Economics profession.
I sense the wait will continue for a while longer.
When Professor Krugman says no one saw the financial crisis coming, he is talking about 99% of the Economics profession (even here there were a handful of exceptions like William White). There were individuals outside of the Economics profession like myself who did see the crisis coming.
Professor Krugman is right there was an empirical failure. He description of the failure as financial innovation getting around Depression-era bank safeguards misses the fundamental point. This was an opacity driven crisis and the safeguards Wall Street got around were the ones preventing the sale of opaque securities.
The Information Matrix helps to understand why this opacity driven crisis occurred. Wall Street knows it makes a lot of money selling opaque products in the Blindly Betting quadrant. These products are sold based on a story about their value. When the story is called into doubt, there is no logical stopping point in the downward valuation of these products other than zero. As a result, investors who come to doubt the opaque products have an incentive to “run” and try to get their money back as soon as there is any doubt about the valuation story.
Professor Krugman meanwhile is still slapping his forehead and claiming the crisis was the result of sunspots (see Bank Runs, Sunspots and the Information Matrix for a debunking of Diamond and Dybvig’s groundbreaking article in which even they admit they don’t have a story for what causes a financial crisis or bank run).
Professor Krugman then goes on to make a case for why post-crisis macro economics worked pretty well.
The Information Matrix has one other use. It anchors the financial crisis response playbook. Specifically, it says to use the Swedish Model. Under this Model, banks are used as they are designed to protect the real economy. They do so by absorbing upfront the losses on the bad debt in the financial system (see Iceland).
The alternative financial crisis response playbook is the Japanese Model. Under this Model, banks are protected at all costs. Rather than recognizing the losses on the bad debt upfront, policies are adopted to “foam the runway” and have the losses recognized over decades. This places the burden of the bad debt squarely on the real economy.
Naturally, accommodative fiscal and monetary policies have vastly different impacts on the real economy if the Swedish or Japanese Model is being followed. If the Swedish Model is pursued, economic recovery from the crisis is very brisk. If the Japanese Model is pursued, the real economy continues to suffer from economic malaise as the cost of supporting the excess debt strips the real economy of the capital needed for growth.