Nicholas Gruen, CEO of Lateral Economics, highlighted a major problem with Economics today while talking about Nobel prize winning Economist Paul Krugman:

his most brilliant work wasn’t useful, and his most useful work isn’t brilliant.

This problem is not confined to Mr. Krugman.  It extends across much of the profession where it faces the problem its most brilliant work isn’t useful and its most useful work isn’t brilliant.

No place is this better illustrated than in macroeconomics.

Consider for a moment the sheer complexity and mathematical wizardry underlying the econometric models macroeconomists have built to forecast the economy’s performance.  It really is impressive.

It also is useless.

These models don’t predict the important stuff like say recessions or financial crises.  Instead, the models treats these as exogenous events (for those not familiar with this term, the models treat recessions/financial crises as an act of god).

Their models also don’t explain what is the necessary condition for a financial crisis to occur, what triggers it or prevent another crisis from occurring.  So they are useless when a financial crisis occurs as the basis for formulating a response to the crisis.

In case you think I am being overly critical of macroeconomics, the entire finance branch is no better.

Again, the sheer complexity and mathematical wizardry underlying their models for portfolio and risk management are really impressive.

These models are also useless.

Why?  Underlying all of their models is an assumption about information that isn’t true.

Their models don’t assume Perfect Information.  Rather they assume a workaround to arrive at Perfect Information by relying on the Efficient Market Hypothesis.  EMH says insiders who have access to Perfect Information will use this information to set the correct price for an investment in the market.  But what happens in the case of structured finance securities like subprime mortgage-backed deals that don’t have an insider? Oops.

Is there any reason to think adding opaque investments will improve the performance of an investment portfolio or reduce its risk?

No.

As I said, there is a gap between brilliant and useful.

Of course, sometimes there is an idea that is both brilliant and useful.

Regular readers know the Information Matrix is an example of an idea that is both useful and, all modesty aside, brilliant.  It addresses the shortcomings in both the macroeconomists’ models as well as the finance profession’s models.  It also lends itself to useful applications like the Transparency Label Initiative.

But that is not all that it does.  From an economist’s perspective, it combines neoclassical economics and behavioral economics in a single framework.  It explains where financial crises come from and why they occur.  It shows information asymmetry is an interesting market imperfection, but blind betting is a much more important market imperfection (after all, no reason to think blind betting yields the same optimal allocation of resources as informed decision making).

From a non-economist’s perspective, it explains why our financial system is designed the way it is (which is beneficial to finance professor as it saves them from having to get into the details).  It explains how a financial crisis should be responded to (and bailing out banks and pursuing zero interest rate policies/quantitative easing is the absolutely wrong response).

I could go on, but I think I have made the point of just how useful the Information Matrix is and how it is a game changer for the Economics/Finance profession.