Did Econ Nobel Winners Make Crisis Worse?

Economic Fundamentals, Information Matrix, Japanese/Swedish Models

10 Oct 2017

Regular readers know that financial crises take place in the Blind Betting quadrant of the Information Matrix.

Information Matrix

	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

Why?

Financial market participants have only story driven guesses as to the value of the opaque securities in the Blind Betting quadrant. And when the story is called into doubt, so too the guessed at value.

Financial crises and their associated “runs” occur when market participants come to doubt the story and their guess as to the value of the opaque securities they are exposed to. In the absence of facts, when doubt sets in there is no logical stopping point in the downward valuation of these securities other than zero. Investors know this and this gives them an incentive when doubt starts to set in to “run” and try to get their money back.

So what does this have to do with Economists who win their version of the Nobel Prize?

A reason Wall Street loves opacity is the existence of the blind betting quadrant isn’t taught in Econ 101. As recently as 2015, it was absent from the 20 leading introductory economics textbooks. Based on my conversations with researchers in Information Economics this is unlikely to change soon. The textbook authors are patiently waiting for someone with a PhD in Economics to discover the blind betting quadrant.

Why is the failure to teach or research the blind betting quadrant important? The ongoing failure helps Wall Street continue to sell opaque securities.

How?

The Economics profession acts as a significant barrier to the elimination of opacity. Its recommendations on how to end or prevent a financial crisis dominate the public discourse. This is particularly true when a Nobel-prize winner speaks. But is there any reason to think their recommendations are of any value? After all, they are unaware of or purposefully ignore the quadrant of the Information Matrix where I showed financial crises actually occur.

In his Nobel speech, Hayek discussed this problem when a Nobel-prize winning Economist speaks.

the Nobel Prize confers on an individual an authority which in economics no man ought to possess.

This does not matter in the natural sciences. Here the influence exercised by an individual is chiefly an influence on his fellow experts; and they will soon cut him down to size if he exceeds his competence.

But the influence of the economist that mainly matters is an influence over laymen: politicians, journalists, civil servants and the public generally. There is no reason why a man who has made a distinctive contribution to economic science should be omnicompetent on all problems of society – as the press tends to treat him till in the end he may himself be persuaded to believe. One is even made to feel it a public duty to pronounce on problems to which one may not have devoted special attention.

I am not sure that it is desirable to strengthen the influence of a few individual economists by such a ceremonial and eye-catching recognition of achievements, perhaps of the distant past.

I am therefore almost inclined to suggest that you require from your laureates an oath of humility, a sort of hippocratic oath, never to exceed in public pronouncements the limits of their competence.

When it came to pronouncing what policies should be pursued to end an opacity driven financial crisis, even the non-Nobel-prize winning Economists were well beyond the limits of their competence.

As a result, we ended up pursuing the Japanese Model for handling a crisis. Under this model, the banks and banker bonuses are saved at all cost. The burden of the excess debt in the financial system is put on the real economy with very negative results. The capital the real economy generates and is needed for reinvestment if the economy is to grow is instead used for debt service on the excess debt. The result is economic malaise (look at Japan which has experience 2+ decades of this).

The alternative had the Economists not spoken up was to pursue the Swedish Model. Under this model, the banks are used as they are designed to absorb the losses on the excess debt. This saves the real economy and allows it to continue to grow as the capital it generates is used for reinvestment.