Yale professor Gary Gorton is the gift that keeps on giving.  His latest gift was to inform a Wall Street journal reporter that the reporter’s article:

wouldn’t be “accurate except within your understanding of the crisis. Basically you don’t understand the crisis.”

The reason I refer to this as a gift is not just that it is an obnoxious comment, but in making this obnoxious comment Professor Gorton is telling us he does understand the crisis.  Is there any reason to think this is true?

No!

Regular readers of this blog and Transparency Games know I have debunked Professor Gorton’s work on numerous occasions.  Hard as it is to believe, it is actually more fundamentally flawed than the This Time Its Different work by Professors Rogoff and Reinhart.  And that is really saying something given they buried the bar for getting something published in a peer reviewed Economic journal anywhere from 10 to 15 feet underground.

But it is worth debunking once more since the Wall Street Journal reporter observed:

Many economists consider Mr. Gorton a top expert on financial crises. His fans include former Federal Reserve Chairman Ben Bernanke, who praised the professor’s insights in 2010.

The starting point for debunking Professor Gorton is a famous expression often attributed to Einstein:

If you can’t explain it to a six year old, you don’t understand it yourself.

Which pretty much confirms Professor Gorton is full of hot air as it is a very safe bet the reporter is older than six.

However, for those of us who do understand the financial crisis, there is no reason not to explain it in terms a six year-old could understand.  And to do this we need a physical model of a security.  Representing a transparent security we will use a clear plastic bag with a $10 bill inside.  Representing an opaque security we will use a brown paper bag which initially also has a $10 bill inside.

When asked how much is in each bag, the six year-old would say both bags have a $10 bill inside.

Next, I will tell a story about how I bought two bagels and the seller only accepted cash.  Fortunately for me, I had 2 $10 bills.  So I used one $10 bill to pay for the bagels and got back $7.

Once again, I will ask the six year-old how much is in each bag.  This time, the six year-old will tell me the clear plastic bag has $10 and the brown paper bag has $7.

So I will continue my story and tell him while eating the bagels, I was thirsty.  So I bought myself an iced tea to drink.  The tea cost $3 dollars.

Once again, I will ask the six year-old how much is in each bag.  This time, the six year-old will tell me the clear plastic bag has $10 and the brown paper bag has $4.

I’ll ask if the six year-old is sure about this.  Naturally, the six year-old understands the $4 could also have been spent.  The six year-old’s response is the brown paper bag has $0 in it.

Well reader, how much is in the brown paper bag?  Is it still the initial $10 (after all, I didn’t say I used the money in the brown paper bag to pay for what I ate or drank)?  Or is it it $0?

Let’s map this story to the Information Matrix.

Information Matrix

	Seller’s View
Buyer’s View		Plastic Bag	Paper Bag
	Plastic Bag	Perfect Information	Antique Dealer Problem
	Paper Bag	Lemon Problem	Blind Betting

We can then ask if you were designing a financial system which quadrant of the Information Matrix would you want transactions to occur in.  The only quadrant the Economics profession has shown that delivers positive results is the Perfect Information quadrant.  Not surprisingly, this is the quadrant a six year-old would choose.  It is also the quadrant the design of our financial system attempts to make all transactions occur in.

Unfortunately, transactions occur in the Blind Betting quadrant.  As Wall Street knows, everyone likes a good story.  And it is from this quadrant financial crises emerge.  They emerge when the story used to value the paper bag/opaque security is called into doubt.  When this happens, as my story to the six year-old showed there is no logical stopping point in the downward valuation of these paper bag/opaque securities other than zero.  Hence, owners of these securities have an incentive to “run” to try to get their money back as soon as the valuation story is called into doubt.

What I have just done is illustrate how our financial system is designed to work and how securities that are valued based solely on stories that cannot be verified are the source of financial crises.  And I did it in such a way both a six year-old and a bright Wall Street Journal reporter can easily understand it.

Professor Gorton is well known for introducing the concept of informationally insensitive debt.  A quick look at the Information Matrix shows this debt doesn’t exist.  All debt is informationally sensitive.  The only question is whether or not buyer and/or seller has access to the information they need to know what they own.

The Wall Street Journal article focused on Professor Gorton’s description of the financial crisis:

Mr. Gorton has likened the 2008 crisis to an old-fashioned bank run. But instead of anxious depositors emptying their bank accounts, Mr. Gorton has said the bank run of a decade ago played out in the so-called repo market.

This is where banks like Lehman Brothers raised short-term cash by selling securities and repurchasing them later at a slightly higher price. When investors questioned the value of those securities, the repo market froze up.

This description is consistent with the Information Matrix’s explanation of financial crises.  Unfortunately, it reflects a certain intellectual laziness.  It doesn’t ask whether investors also questioned the value of other opaque securities.  This includes the securities issued by opaque banks like Lehman Brothers.

If the only problem was a disruption in a single funding market, we wouldn’t have experienced a financial crisis.  I worked in the asset/liability management area of a a Too Big to Fail bank and can assure you banks have multiple markets in which they fund themselves.  They are never dependent on a single market for their funding.  Hence, we know the story of a run on the repo doesn’t explain the acute phase of the Great Financial Crisis in 2008.

However, when we look at the acute phase as a run on all the opaque securities in the global financial system, we can now explain what happened and why it happened.