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 the problem is actually the PhD Economists.  With the one exception, PhD Economists confuse the little they know about transparency, our financial system design and how to respond to a financial crisis with being an expert.  The term of art for referring to PhD Economists who make this mistake is Confident Idiots.

Let me give you one example of these Confident Idiots in action.  In early 2009, I met an MIT professor who had championed tougher bank capital requirements.  To help the professor understand where I was coming from in the conversation, I provided my background.  This includes stints at the Fed as well as working for a Too Big to Fail bank in its capital management area.  Then, based on this expertise, I observed in the absence of transparency, bank capital is an easily manipulated, meaningless accounting construct.  As a result, calling for tougher bank capital requirements without simultaneously calling for transparency was more likely to help the bankers than bring about any theoretical benefits tougher bank capital requirements might offer.

The professor’s immediate response was to inform me it was easier to manipulate the value of the individual positions a bank held than it was to manipulate the bank capital account itself.

I turned to a Stanford Finance professor who also championed and wrote a book on tougher bank capital regulations.  I asked if the Stanford professor thought the statement was true.  The professor’s head nodded in agreement.

Is this statement true?  Of course it is not true.  This is easily shown using Accounting 101.  Imagine a bank lent a $1,000 and the borrower now can only repay $750.  What happens to the $250 loss.  Normally, it is charged off against the bank’s capital accounts (technically, its loan loss reserve).  But what happens if bank regulators don’t want to see a decline in the bank’s capital accounts.  Then the bank engages in “pretend and extend”.  Rather than  charge off the $250 loss, the bank pretends it will be repaid.  The impact of manipulating the value of this individual position is to also manipulate the bank’s capital accounts at the same time.  In this case, bank capital accounts are overstated.

Have bank regulators ever done something like this?  In the 1980s, bank regulators engaged in this activity with the loans to less developed countries.  These loans traded for 50 cents on the dollar, but were held on bank balance sheets at 100 cents on the dollar.  In 2008, bank regulators moved with the accounting professions blessing to suspend mark to market accounting for subprime mortgage-backed securities and related derivatives.  In this case, the securities and related derivatives were trading for 20 cents or less on the dollar.

Wouldn’t you expect the champions of tougher bank capital requirements to know a little about Accounting 101 and the tactics bank regulators use to manipulate the reported level of bank capital?  Knowing these Confident Idiots weren’t listening, I didn’t even bother mentioning how easy it is for bank management to game bank capital regulations.

Both of these professors are shining examples of Confident Idiots.  Both didn’t hesitate to present themselves as experts to an individual who by training actually was an expert.  To be fair, when these professors attend meetings of PhD Economists, they probably are the experts on bank capital.  But this isn’t a tough bar to get over considering it is buried twenty to thirty feet underground.