The Information Matrix provides the framework for understanding financial crises using behavioral economics.

Behavioral economics recognizes people like a good story.  In fact, people can like a narrative so much they behave in ways that are irrational.

Wall Street understands this.  Behind every investment product Wall Street sells is a narrative designed to make the product sound appealing.

In the run up to the Great Depression, it was thought making investors responsible for all losses on their investments would be enough to prevent investors falling prey to Wall Street’s story telling prowess.  The stock market crash of 1929 and bank runs throughout the early 1930s showed this wasn’t true.

In response to these events, the financial system was redesigned in the early 1930s.  Specifically, transparency was introduced.  The government was given the responsibility for ensuring the disclosure for all publicly traded securities was sufficient so investors could know what they owned.

The Information Matrix shows the intent of the redesigned financial system was to move the vast majority of investments from Wall Street’s preferred Blind Betting quadrant into the Perfect Information quadrant.

Information Matrix

Moving investments into the Perfect Information quadrant made sense on a number of levels.  First, the Perfect Information quadrant is where all the theories developed under classical economics about how the market optimally allocates resources work.  Second, it allowed investors to Trust, but Verify the story Wall Street told.

Keep in mind, behavioral economic’s observation people like a good story operates in both the Perfect Information and Blind Betting quadrant.  The key difference between the two quadrants is in the Perfect Information quadrant the story can be verified and in the Blind Betting quadrant the absence of the necessary information means the story cannot be verified.

Whether the story can be verified or not results in a vastly different response when Wall Street’s valuation story is called into doubt.  In the Perfect Information quadrant, the story can be verified and the doubt dismissed.  In the Blind Betting quadrant, the story cannot be verified.  Not only is the doubt not dismissed, but the logical follow-up question arises:  is the investment worth anything?  This too cannot be verified.  Investors recognize this and, as behavioral economics suggests, naturally panic.  The result is a “run” to get their money back.

Please note, if you look at the total capital lost during a financial crisis, the investors’ panic does not account for much of this lost capital.  The vast majority of the capital has already been lost as a result of trusting, but not verifying Wall Street’s story.

Behavioral economics allows us to understand the classic financial crisis panic.  The Information Matrix framework shows why the financial crises always start in the Blind Betting quadrant.

Together they explain why if you want to minimize the chances of another financial crisis, you minimize the size of the Blind Betting quadrant.