It was almost a decade ago when the Queen of England asked at the London School of Economics how come the Economics profession didn’t see the crisis coming.  Since then, the Economics profession has not offered up an honest answer.

First, it offered up the excuse financial crises are hard to predict.  This is a bit of a problem when the policies pursued by central banks are based on predictions of future economic activity made by Economists and the impact these policies will have on that activity.  Saying you cannot predict major turning points in the economy like a financial crisis undermines the idea Economists should have anything to do with setting monetary policy.  Oops.

Second, if offered up the excuse you could not possibly think we could have predicted the Great Financial Crisis would start on August 9, 2007.  Nobody asked the Economics profession to get the date the crisis started right.  The Economics profession was asked to know when the conditions a financial crisis might occur were present and to warn a crisis could occur.  It didn’t.  Oops.

Third, it offered up the new excuse Economists are a bunch of bright people, but they could never imagine given everything the Economics profession then knew a financial crisis could have occurred.  This excuse held up until Nobel prize winning Economist Joseph Stiglitz let the cat out of the bag and pointed out the banking sector wasn’t included in the economic models used by the Economics profession.  Oops.

Fourth, it offered up a handful of PhD Economists did see the financial crisis coming so it is unfair to say the Economics profession didn’t see the crisis coming.  While touting this handful of seers, the Economics profession didn’t mention how it marginalized these individuals and ridiculed their “prognostication” in the run-up to the crisis.  Oops.

Fifth, it looked for another field that does forecasts and said Economic forecasts are like weather forecasts and weathermen sometimes get their forecast terribly wrong.  I really liked this excuse until I realized the very people who are in charge of preventing the next financial crisis using macro prudential policies are saying we are likely to get another financial crisis because they made another bad forecast.  Oops.

Sixth, it went on the offensive and said forecasting is a small part of what the Economics profession does and the Economics profession has made all sorts of great contributions in these other areas.  To the extent people actually think about the Economics profession and its impact on their lives at all they start by focusing on issues like do they have a job and what is the rate on their mortgage or car loan.  Please note, these are all related to that small part of economics that cannot get its forecasting right and in doing so undoubtedly promotes the wrong policies.  Oops.

There have been other excuses the Economics profession has offered up.  But I have forgotten them as they are more pathetically bad than the ones I put on the list.

I would like to think the Economics profession has spent the last decade trying to understand why their theories left them blindsided by the financial crisis.  However, there is no evidence the profession has figured out the answer yet.

However, for those of us who do understand the financial crisis, there is no reason not to explain it in terms the Queen or a six year-old could understand.  And to do this we need a physical model of two securities.  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 the Queen can easily understand it.

Of course, to finish answering the Queen’s question all I have to do is point out the Economics profession is completely unaware of the existence of the Blind Betting quadrant.  It is not in the profession’s literature and it is not in the profession’s models.

I am confident the Queen would understand the Economics profession could not see the crisis coming because it wasn’t even looking in the direction from which financial crises emerge.