Prospect Magazine asked a number of PhD Economists and Economic commentators what is the one lesson they wish Economists would learn.  Imagine my surprise when I read the reply by the Financial Times’ Martin Wolf in which he is calling for the new Economic model I built.

Macroeconomics needs to grapple with three linked questions. First, what causes financial crises? Second, what policies would best reduce the risks of such crises? Third, what should the policy response be to crises once they have happened?

On the first, how should we understand the interaction between the financial and monetary systems and the real economy? Sometimes the economy seems to depend on a combination of asset-price bubbles with the unsustainably rapid growth of debt. Why should this be so? On the second, are there more sustainable ways to generate demand? Might redistribution of income towards spenders be the answer? What role can government spending play?

On the third, are there alternatives to a combination of heavy government borrowing with supportive monetary policy? This combination has brought recovery. But the indebtedness built up before the crisis has, in part, just shifted onto the public sector. Moreover, even the private sector’s deleveraging has been modest. Economies remain fragile. Macroeconomics is, alas, not healthy.

The fact a decade has passed since the acute phase of the Great Financial Crisis and all the PhD macro economists have not been able to answer these three linked questions is a sure sign there is a problem with current Economic theory.  This isn’t a surprise.  Recall their answer to when the Queen of England asked why they hadn’t seen the financial crisis coming is Economic theory says financial crises are hard to predict even for smart people like themselves.

Of course, those of us who did predict the financial crisis weren’t constrained by existing Economic theory.  In my case, I understood exactly why the existing Economic theory cannot be used to predict a financial crisis.

All of Economics is built on an assumption about the information the buyer and seller have when they transact.  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 Information Matrix moves the Economics profession past information asymmetry.  It introduces the idea transactions occur where neither the buyer or seller has access to the information they need to know what they own or are buying.  These transactions occur in the Blind Betting quadrant.

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

Recognition of the Blind Betting quadrant’s existence has profound ramifications for Economics.  For example, it embraces rather than wrestles with the simple fact people are both rational and enjoy a good story.  Rational behavior 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 behavior occurs in the Perfect Information quadrant.  The Behavioral Economics’ lover of a good story falls in the Blind Betting quadrant.

With this brief background on the Information Matrix, let’s move on to answer Mr. Wolf’s questions.

First, what causes financial crises?

To understand where financial crises come from, you have to understand why the global financial system is designed the way it is designed.  The design wasn’t an accident.  The Great Depression era policymakers who designed the global financial system knew where financial crises came from.

Regular readers are familiar with the Pecora Commission and how it showed Wall Street prefers selling the 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.  Wall Street puts its time and effort into finding people (individuals, asset managers, etc) who will buy and sell 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.  If the opaque sectors of the financial system are large enough, the result is a financial crisis.

If you look at the acute phase of the Great Financial Crisis, you will see the problem the Pecora Commission identified with opaque securities is exactly what happened.  Wall Street sold opaque subprime mortgage-backed securities and related derivatives with a good story about how house prices have never declined nationally.  Then, the value of the opaque securities was called into doubt when Too Big to Fail bank BNP Paribas said it couldn’t value them.  This prompted Ben Bernanke to famously opine subprime was contained.  What he missed was the doubt about the value of the subprime securities was spreading doubt along the opacity fault line in the financial system.  Investors asked who was holding the losses on the subprime securities.  When they discovered the opaque banks were, the acute phase of the Great Financial Crisis was on.

Financial crises originate in the Blind Betting quadrant.  They occur when the valuation story told about the opaque securities in this quadrant is called into doubt.

Second, what policies would best reduce the risk of such crises?

If you were going to design a financial system, which quadrant of the Information Matrix would you want virtually all of the transactions to occur in?  Clearly, it would be the Perfect Information quadrant.  It is only in this quadrant buyers and sellers know what they own or are buying.  It is only in this quadrant that all the benefits we associate with markets are achieved.

Great Depression era Policymakers recognized the need to be in the Perfect Information quadrant.  But first, they had to understand how Wall Street was so successful in selling opaque securities when everyone understood the financial markets operated under the principle of Buyer Beware.  The Pecora Commission showed Wall Street was so good at phishing for fools for any specific investment that investors as a group were unable to force any issuer to provide the disclosure they needed to know what they owned.

With this answer, policymakers understood the only way to eliminate the financial crises caused by opaque securities was to reduce, if not totally, eliminate the existence of opaque securities.  Doing so requires transparency.  They made it the government’s responsibility to ensure disclosure so investors could know what they owned.

Prior to Wall Street capturing the process for setting disclosure requirements, the government through the SEC effectively limited the existence of opaque securities.  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.

Third, what should the policy response be to crises once they have happened?

The policy response should definitely not be the policies that were pursued when the acute phase of the Great Financial Crisis occurred.  Developed nations followed the Japanese playbook for how to respond to a financial crisis by saving the banks.  Doing so, they lost the real economy, increased the outstanding debt and failed to generate a self-sustaining recovery.

The policy response should have been and still could be to use the playbook developed and implemented by the Great Depression era policymakers.  These policymakers didn’t stop with introducing transparency.  They also redesigned the financial system to protect the real economy should a financial crisis occur.  They did this by introducing deposit insurance.  Deposit insurance not only eliminates retail bank runs, but it also lets an insolvent bank continue in operation until such time as the regulators shut it down.  By design, banks like JP Morgan and Goldman need the US; but the US doesn’t need specific banks with names like JP Morgan and Goldman.

Please re-read the last sentence as it is very important for how a financial crisis should be handled.

The Great Depression era policymakers understood deposit insurance makes the taxpayers an insolvent bank’s silent equity partner.  They understood with the taxpayers as the silent equity partner a central bank could be a lender of last resort to insolvent banks too.   As a result, an insolvent bank can stay open indefinitely and keep providing payment services and loans.  [If you doubt me, just look at the mid-1980s Savings and Loan Crisis where these insolvent institutions with deposit insurance operated for years before being closed by the government.]

This ability to stay open while insolvent is the key to responding to a financial crisis.  It allows the brunt of the crisis to be contained in the financial system.  Banks, like all other investors, should absorb the losses on all their bad asset exposures at the start of the crisis, rather than being bailed out or having policies to foam the runway so they can recognize their losses over time.  This protects the real economy. [If you doubt me, just look at how Sweden handled its financial crisis in the early 1990s and Iceland handled its financial crisis during 2008/2009 and how quickly a self-sustaining recovery occurred after the losses were realized.]

But what happens to the specific insolvent banks?  It depends on whether they are viable or not after recognizing their losses.  A bank is viable if it can generate earnings and therefore rebuild its book capital either through retained earnings or by attracting new capital investment.  If a bank cannot do this, the government should eventually close it.

Of course, transparency is critical when going through the loss recognition step.  Individuals and businesses trust their independent confirmation the losses have been dealt with.  This gives them the confidence to continue taking the risks we associate with a normally functioning economy.

The Depression Era policymakers didn’t stop with transparency and deposit insurance.  They also introduced the automatic stabilizer programs.  As Nobel prize winner Paul Krugman discovered, it was these programs that prevented a depression during the Great Financial Crisis and not government policies adopted during 2008/2009.

Is there a case for additional fiscal stimulus in the face of a financial crisis?  Yes, but with the right set of automatic stabilizer programs it is not absolutely necessary.

Is there a cases for accommodative monetary policy in the face of a financial crisis?  Maybe, but only when the limitations on monetary policy are understood.  For example, according to a former member of the Bank of England’s Monetary Policy Committee, it takes 18 months for a change in interest rates to make its way into the real economy.  So monetary policy cannot do anything to impact the current acute phase of a financial crisis.

At this point, my post is already too long.  I hope I have conveyed the Information Matrix allows us to understand where financial crises come from, why they happen, how we should respond and what can be done to prevent future crises.