Nobel prize winning Economist Paul Krugman explains what is a sure sign of when a PhD Economist is being a “derp”:

OK, so some economists got it wrong. That happens to everyone, unless you’re too cowardly to make any testable predictions at all. But what you’re supposed to do when things don’t play out as you predicted is (a) acknowledge the mistake (b) try to understand what went wrong (c) revise your framework in an attempt to avoid making the same mistake again. …

What’s striking about the economists …  is that as far as I can tell none of them has even gotten to step (a), acknowledging their mistake. They kept saying the same wrong thing year after year (which is what makes it derp), and even those who eventually stopped saying the same thing never admitted past mistakes….

Being an inflation derper means never having to say you’re sorry, or even admit that you were wrong — and definitely means learning nothing from your mistakes

This is quite the indictment of PhD Economist derps because it is true.

No place does this hold truer than when PhD Economists talk about information-insensitive debt, safe assets, bank capital, the idea the monetary policy response to the acute phase of the financial crisis was helpful or their DSGE models have been modified so now they are capable of identifying those policies that would be helpful in ending financial crises.  Each of these is an example of Economics PhD derp.

The Information Matrix shows why each of these is an excellent example of PhD Economists in full derp mode.

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

Rather than bore the reader by showing why every example in my list is an example of PhD Economist derp, I’ll just look at information-insensitive debt.

What is information-insensitive debt?

In a May 9, 2009 paper for the Atlanta Fed, Yale Professor Gary Gorton coined the term and defined it as:

Intuitively, information insensitive debt is debt that no one needs to devote a lot of resources to investigating.  It is exactly designed to avoid that.

He has two examples of information-insensitive debt:

• Demand deposits; and
• The senior tranches of securitized debt.

He notes that the senior tranches of securitized debt are

informationally-insensitive, though not riskless like demand deposits.

Regular readers of this blog know that the concept of informationally-insensitive debt is incompatible with the Information Matrix.  Why?

Because debt, like all investments, is informationally-sensitive!  What differs between investments is if all the information an investor needs to know what they own is disclosed and how much effort it takes to analyze this information.

The demand deposits Professor Gorton describes as being informationally-insensitive belongs in the Perfect Information Quadrant of the Information Matrix.

When depositing money with an FDIC insured bank, the investor is told that their money is insured up to $250,000 per account.  This is information.  With the information about the government guarantee, investors do not need to devote a lot more resources to investigating the financial solvency of the bank.  All they have to track is the maximum  amount guaranteed to know how much of their investment will be returned.

Contrast depositing money in a bank with investing in the senior tranches of structured finance securities.

If these securities were in the Perfect information quadrant, they would disclose the current performance of the underlying collateral as well as the terms of the deal.  The investor would then uses this information in the analytical and valuation models of their choice to determine if the cash flow on the underlying collateral will be adequate to return their investment.  Clearly, an investor who does his homework when there is this level of disclosure is going to use dramatically more investigative resources before investing in the senior tranches of a structured finance security than before investing in demand deposits.

However, the senior tranches of structured finance securities don’t provide observable event driven disclosure on the underlying collateral.  In fact, these securities are designed to be in the Blind Betting quadrant and valued based on a story told by Wall Street.  In this case, the story was and still is investors could/can trust the ratings provided by the rating firms on the debt.

Why has informationally-insensitive debt taken hold among the Economics PhD derps? We will never know for sure, but their devotion to it suggests it offers a more compelling explanation of financial crises than Diamond and Dyvbig’s sunspots.

If this is true, it might be useful to test the informationally-insensitive model against the Information Matrix to see how both describe the events of August 2007 and therefore how the entire subsequent financial crisis should be interpreted.

According to  the November 9, 2010 version of Gorton and Metrick’s Securitized Banking and Run on the Repo paper,

The banking system has changed, with “securitized banking” playing an increasing role alongside traditional banking. One large area of securitized banking – the securitization of subprime home mortgages – began to weaken in early 2007, and continued to decline throughout 2007 and 2008. But, the weakening of subprime per se was not the shock that caused systemic problems. The first systemic event occurs in August 2007, with a shock to the repo market that we demonstrate using the “LIB-OIS,” the spread between the LIBOR and the OIS, as a proxy. The reason that this shock occurred in August 2007 – as opposed to any other month of 2007 – is perhaps unknowable. We hypothesize that the market slowly became aware of the risks associated with the subprime market, which then led to doubts about repo collateral and bank solvency. At some point – August 2007 in this telling – a critical mass of such fears led to the first run on repo, with lenders no longer willing to provide short-term finance at historical spreads and haircuts. [emphasis added]

Under the informationally-insensitive model, what happened in August 2007 is an unknowable mystery that resulted in the first repo run.

Is is true it is an unknowable mystery?  According to an article by Larry Elliott, the Economics Editor for The Guardian,

On the face of it, there was nothing especially memorable about August 9 2007.

… It was, however, the day the world changed. As far as the financial markets are concerned, August 9 2007 has all the resonance of August 4 1914. It marks the cut-off point between “an Edwardian summer” of prosperity and tranquillity and the trench warfare of the credit crunch – the failed banks, the petrified markets, the property markets blown to pieces by a shortage of credit. 

What happened on August 9, 2007?

According to a report by BBC News,

Investment bank BNP Paribas tells investors they will not be able to take money out of two of its funds because it cannot value the assets in them.

Specifically, BNP Paribas could not value the subprime mortgage backed securities in these funds.

Why could it not value these securities?

As was disclosed by the rating agencies in their testimony before the US Congress a month later, these securities could not be valued because there was no access to the data needed to monitor them and to make timely rating changes.

Under the Information Matrix, what happened in August 2007 is not a mystery.  It was the month in which BNP Paribas called into doubt Wall Street’s story about the valuation of these securities.

What happened next when the valuation story of Blind Betting quadrant securities is called into doubt was fully predictable.  In the absence of disclosure which would have provided logical stopping points other than zero in the decline in price of these securities, the market for these securities froze as prices plunged.

Once this announcement had been made, both the cause (the lack of data) and how to stop the global financial crisis (provide the data) were easy to identify.