Institute for Financial Transparency

Shining a light on the opaque corners of finance


Economists and Their Inability to Say They Don’t Know

Why do Economists, particularly macro-economists, have such a difficult time saying “I don’t know” rather than confidently offering an ill-informed opinion?

Consider for a moment why the Economics profession might be driving the public’s loss of trust in experts.  The Economics profession, or at least its macro-economist members, holds itself out as being THE EXPERTS on financial crises,  how to end them and how to prevent them in the future.

In one of those articles Economists love to cite to show their expertise on financial crises, Diamond and Dybvig developed a model for why it is rational for bank depositors to engage in bank runs.  However, the authors make no claim as to understanding what triggers the bank run in the first place.  Instead, they offered up as a possible explanation sunspots.


When I pointed out the authors suggested sunspots were necessary for their model to work, several Economists went to great pains to tell me other Economists had shown sunspots weren’t necessary for the authors’ model to hold.  However, none of these Economists had an explanation for why the bank run started in the first place either.

Regular readers know the Economics profession’s inability to understand where financial crises come from or how to end them reflects a giant gap in the profession’s theories.  After Adam Smith postulated perfect information and Akerlof and Stiglitz showed information asymmetry existed, the profession failed to fill in the rest of the Information Matrix.  Had they done so, the profession would have known where financial crises come from and how to end them.

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

Financial crises come from the Blind Betting quadrant.  They occur when the stories used to support the valuation of the securities, including bank deposits, that make up this quadrant are called into doubt.  When the valuation stories are called into doubt, there is no logical stopping point in the downward valuation of these securities other than zero.  Hence, there is an incentive to “run” and try to get your money back.

No place is this failure to recognize the existence of the Blind Betting quadrant more ironic than when Economists try to defend what they see as an assault on Economics.

In a recent column, Noah Smith makes the following defense of the Economics profession’s tendency to opine with much greater confidence than their research warrants:

Mortgage-backed securities are a more troubling case, because so few people were sounding the alarm about the models used to determine the risk of these assets in the years before 2008. But because the banks that issued these mortgage-backed bonds ended up holding so many of them — putting them in danger of bankruptcy in 2008 — it seems very likely that the mispricing of these bonds was mostly a genuine mistake rather than a conspiracy. Human stupidity and groupthink is far more likely culprit than a sinister expert cartel

Apparently Mr. Smith is unaware of the fact mortgage-backed securities are designed to be opaque and the mis-pricing of these securities was not a genuine mistake, but was intentional.  Wall Street makes much more money selling high margin, opaque securities than it does selling low margin, transparent securities.

Here is another classic example from another article by Economists trying to defend Economics:

Another misconception is that most economists think that markets are perfect and frictionless. Again, nothing can be further from the truth. While a perfectly competitive market is a useful benchmark, most interesting economics is about the study of market imperfections: real markets are characterised by asymmetric information, frictions, market power; all features that are central to modern theories and that are essential in determining key outcomes. This is the subject matter of the best economists… [emphasis added]

Apparently Economists haven’t study the financial markets.  In the 1930s, securities laws were adopted and the SEC was created with the intent of forcing all securities into the Perfect Information quadrant.  However, Wall Street managed to get around the laws and capture the SEC.  As a result, we have opaque securities like sub-prime mortgage-backed and bank securities which are designed to be in the Blind Betting quadrant.  It appears this market imperfection was missed by not only the “best economists”, but the rest of the Economics profession too.  If it hadn’t been missed, the Economics profession would have seen the financial crisis coming.

In another defense of the Economics profession, Harvard professor Dani Rodrik suggests ten commandments for non-economists when talking about Economics. I’ll highlight my favorite one.

8.  Economists don’t (all) worship markets, but they know better how they work than you do.

I haven’t figured out what bothers me more about his statement: the incredible level of condescension or it was written ten years after the financial crisis showed it is wrong.

The Economics profession failed to develop the Information Matrix or recognize the existence of the Blind Betting quadrant.  This failure stands as evidence Economists don’t know how markets work better then you or I.

Of course, acknowledging you don’t know why a financial crisis happened means you have to do research into the causes of the current crisis before confidently offering advice on what policies to pursue to end the crisis.  Did this conspicuous lack of research stop the Economics profession in 2008 or 2009 or later offering up policies for ending the financial crisis?  Absolutely not.

Did their recommended policies work?  As shown by the rise of populism and the rejection of experts, absolutely not.

And here is where the Economics profession grabbed center stage in undermining the public’s trust in experts.

It was apparent to everyone the Economics profession’s policies including saving the banks at all cost meant the real economy and not the bankers bore the brunt of the fallout from the financial crisis.

Let me repeat this so even an Economist can understand it: the Economic profession’s theories for how to respond to a financial crisis were and still are wrong.

Non-economists know this because just like the models favored by Economists failed to include the financial sector, the theories favored by Economists for how to respond to a financial crisis failed to include the financial sector.  Their theories ignored banks are designed to absorb losses and protect the real economy.