“You never change things by fighting the existing reality. To change something, build a new model that makes the existing model obsolete.” — Buckminster Fuller

Since the Great Financial Crisis began in 2007, I have found myself having frequent exchanges with PhD Economists about transparency, how our financial system is designed and how to respond to a financial crisis.  Only one of these exchanges has ever yielded a positive outcome.

At first, I thought it was me.  After all, I am not the world’s greatest storyteller (most of them are located on Wall Street).  However, I am armed with the best props.  My physical model of a clear plastic bag and a brown paper bag not only demonstrates transparency, but also shows why our financial system is designed the way it is and how to respond to a financial crisis.

Belatedly, I have come to realize I will never change things by fighting for change within the existing reality.  So taking a page from Buckminster Fuller’s playbook, I am going to change Economics by building a new model that makes the existing model for practicing Economics obsolete.

Intuitively we know the existing model for practicing Economics is obsolete.  The Queen of England pointed this out when she asked in November 2008 why the Economics profession didn’t see the financial crisis coming (her exact words to a meeting of PhD Economists at the London School of Economics were “why did nobody notice it?”).

Stephen Williamson, the Stephen A. Jarislowsky Chair in Central Banking at the University of Western Ontario, tweeted what has become the Economic Profession’s go to response to the Queen’s Question:

Economic theory tells us exactly why crises are unpredictable-no matter how smart we might be. That doesn’t prevent people from predicting crises. On any given day someone’s doing it. So which of those people should we listen to right now? (tweeted 9:23 AM – 16 Apr 2018)

The Queen did not ask “why did the Economics Profession not predict the Great Financial Crisis would start on August 9, 2007”.  She asked a much different question.  The Queen’s Question focuses on why was the Economics Profession not saying the probability of a financial crisis occurring was increasing and had reached a very high level in the run-up to the financial crisis.

The reason the Economics Profession did not say this is the model it uses for practicing Economics is obsolete.

I trust Professor Williamson when he says “Economic theory tells us exactly why crises are unpredictable”.  When he tweeted this, he is telling us the Economic theory used by PhD Economists for the practice of Economics is obsolete.  It is obsolete because it offers no insight into when a financial crisis is more likely to occur.

Please reread the last sentence as it is very important.

If the Economics Profession knew when a financial crisis was more likely to occur, those really smart PhD Economists would tell us it is likely to occur unless we take some action to prevent it.  But according to Professor Williamson and all those PhD Economists who favored his tweet, it doesn’t.

Saying the Economics Profession doesn’t know when a financial crisis is likely to occur also undermines the argument for listening to these smart PhD Economists when a financial crisis does occur.  If they don’t understand beforehand what is going to cause a financial crisis, how likely is it that they can shed any useful light on how to respond and address the cause.

In case you think I am being hard on Professor Williamson and the Economics Profession, at least one member of the Bank of England’s Monetary Policy Committee agrees with this assessment.  As Gertjan Vlieghe observed:

We are probably not going to forecast the next financial crisis, or forecast the next recession. Our models are just not that good.

Or as the Bank of England’s Chief Economist Andy Haldane put it:

It’s a fair cop to say the profession is to some degree in crisis. It’s not the first time it has happened. It happened back in the 1930s and [during] the Great Depression. But out of that something good spread. It brought us [John Maynard] Keynes and the birth of modern macro-economics. Out of this crisis, there could be a rebirth of economics. I’m not someone who would say that all that’s been done in the past is terrible. It’s just that the models we had were rather narrow and fragile. The problem came when the world was tipped upside down and those models were ill-equipped to making sense of behaviours that were deeply irrational.

Shorter:  the economics profession built models based on rational behavior and there is nothing about a financial crisis or its aftermath that conforms to these models.

So it is time for a new model that can at a minimum handle irrational behavior and predict financial crises to replace the obsolete model.

Fortunately for me, all of Economics is built on an assumption about the information the buyer and seller have when they transact.  I say fortunate, because since I was first taught about the Lemon Problem in my freshman Econ 101 class, the economics profession has not moved past information asymmetry.

The new model for economics starts with 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

The Information Matrix extends the existing Economics model and does so in a way that dramatically reshapes the Economics profession.

For example, economists are wrestling with the simple fact people are both rational and enjoy a good story.  Rational is embodied in Neoclassical Economics.  The lover of a good story is embodied in Behavioral Economics.  If you look at the Information Matrix, you will realize the Neoclassical Economics’ rational occurs in the Perfect Information quadrant.  The Behavioral Economics’ lover of a good story falls in the Blind Betting quadrant.

For example, economists are struggling to explain why the global financial system is designed the way it is designed and where financial crises come from (the paper by Diamond and Dybvig who PhD Economists all cite say sunspots) .  The design wasn’t an accident as the 1930s policymakers knew where financial crises came from.

Regular readers are familiar with the Pecora Commission and how it determined Wall Street prefers selling high margin, opaque securities that occupy the Blind Betting quadrant of the Information Matrix.  Wall Street realizes people like a good story.  Each of these opaque securities comes with a good story (think subprime securities and the story of how house prices have never declined nationally).  Wall Street puts its time and effort into finding people (individuals, asset managers, etc) who will buy these story based securities without having the information necessary to verify all elements of the story are true.  In the current Economic profession vernacular, Wall Street goes phishing for fools.

The Pecora Commission identified the problem with these opaque securities.  It found when the story was called into doubt, the value of the opaque securities headed to zero.  This occurred because the absence of facts eliminates any logical stopping point in the price decline.  Buyers of opaque securities know this.  Hence, as soon as the valuation story is called into doubt, they “run” to get their money back.  This “run” tends to be contagious.  It calls into doubt the value of all the other opaque securities (including banks) in the financial system.  The result tends to be a financial crisis.

With this background, policymakers recognized the need for requiring transparency and making it the government’s responsibility to ensure it was provided.  This was done intentionally rather than create the moral obligation to bailout investors who rely on regulators stress testing opaque banks and telling investors they can survive a financial crisis.  This was done intentionally rather than telling investors what they could or could not invest in or saying investors were a source of risk to the financial system (hello, it is investors who suffer the losses so they are the ones with an incentive to limit their exposure to what they can afford to lose).  This was done intentionally to end financial contagion (after all, when everyone, including the banks, limits their exposure to what they can afford to lose, then any specific bank going out of business doesn’t bring down the rest of the banks).

Prior to Wall Street capturing the process for setting disclosure requirements, the government effectively limited the existence of opaque securities.  Of course, this changed in the 1980s.  For the next two plus decades, we saw explosive growth in opaque securities.  The result was the Great Financial Crisis.  Just as the Information Matrix predicted back in 2006 (note: the timing of the prediction because it was still possible then and through mid-June 2008 to head off the acute phase of the crisis that occurred in September 2008).

Not only did the Information Matrix predict the crisis, but it also explained how to respond to the crisis.  This included what steps were and are still needed to reduce the high probability of another acute stage of the current crisis.

I could go on, but by now everyone except a PhD Economist recognizes how the Information Matrix obsoletes the current model for practicing Economics and replaces it with one that actually does useful things like explaining when a financial crisis is likely to occur, what needs to be done to address the cause of the financial crisis and how to prevent future financial crises.