I came across an article by psychologist David Dunning that does a tremendous job of explaining PhD Economists’ (aka Confident Idiots) actions and their recommendations for how to deal with a financial crisis and regulatory reform.

He provides an insight into a problem PhD Economists face:

The American author and aphorist William Feather once wrote that being educated means “being able to differentiate between what you know and what you don’t.”

What makes it very difficult for PhD Economists to understand and act upon this distinction when it comes to a financial crisis and regulatory reform is their training.  Mr. Dunning explains why this training undermines their ability to make this distinction.

But the problem of unrecognized ignorance is one that visits us all. And over the years, I’ve become convinced of one key, overarching fact about the ignorant mind. One should not think of it as uninformed. Rather, one should think of it as misinformed.

An ignorant mind is precisely not a spotless, empty vessel, but one that’s filled with the clutter of irrelevant or misleading life experiences, theories, facts, intuitions, strategies, algorithms, heuristics, metaphors, and hunches that regrettably have the look and feel of useful and accurate knowledge.

Shorter, because financial crises and the financial system were mentioned in a course they took or an article in an Economics Journal they read, they think they know how to respond to the former and fix the latter.

Consider for a moment my experience with Economic and Finance professors on the subject of bank capital regulations.  These professors have positions at some of our leading universities (think Stanford, MIT, …).  In the decade since the acute phase of the Great Financial Recession, these professors have literally run around the world calling for banks to have more capital.

I first met these professors in early 2009.  I introduced myself and provided what I thought might be a little relevant background:  I previously worked in the capital management area of a Too Big to Fail bank and helped design/lobby for what eventually became known as Basel I.  [Basel I is the framework guiding bank capital regulations.  It has been subsequently updated with Basel II and Basel III.  At its heart, Basel I was all about hiding how much risk banks were taking.  Nothing has changed in the updates.]

Hmmm…. let’s see.  Who should be listened to on the issue of bank capital:  PhD Economists armed with theories, intuitions, and hunches that regrettably have the look and feel of useful and accurate knowledge or an expert in bank capital?

As shown by their decade long globe trotting, these PhD Economists weren’t slowed down in the slightest by the really big problems with the idea they were promoting I pointed out.  Nor did they incorporate my suggestions as to how to fix their idea. [Problem with bank capital is it is an easily manipulated accounting construct.  So easily manipulated, regulators did it during the acute phase of the financial crisis by ending mark to market and letting banks engaged in “pretend and extend” with their bad loans.  The way to cure this problem is transparency.  When the market knows each bank’s current exposure details, it is irrelevant what accounting games regulators permit.]

As Mr. Denning puts it:

incompetent people do not recognize—scratch that, cannot recognize—just how incompetent they are … incompetence does not leave people disoriented, perplexed, or cautious. Instead, the incompetent are often blessed with an inappropriate confidence, buoyed by something that feels to them like knowledge.

A pretty nice summary of PhD Economists.

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Several individuals asked why I didn’t use the Information Matrix, rather than bank capital as an example of PhD Economists as Confident Idiots.  Brevity.  I literally have too many war stories to tell.

For example, consider the Economics Department Head at a major college in the Boston area who informed me the Blind Betting quadrant was just another form of information asymmetry.  A brief look at the Information Matrix shows this not to be true.

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

Both buyer and seller in the Blind Betting quadrant lack access to the information they need to know what they are buying or selling.  In the information asymmetry quadrants (Lemon Problem and Antique Dealer Problem), either the buyer or the seller has the needed information and the other party does not.  When I pointed this out, the department head responded by telling me transactions don’t occur in the Blind Betting quadrant.  Hmmm….  I guess the billions of dollars of opaque subprime mortgage-backed and unsecured bank debt securities that are bought and sold every day don’t count.

The little knowledge the department head had about perfect information and information asymmetry acted to blind the department head to the fact the Information Matrix has 4 quadrants.