I would like to expand on Gene Epstein’s article on Joseph Stiglitz and show how it really applies to much of the Economics profession.

Let’s start with why Professor Stiglitz is and should be admired.

Stiglitz won the Nobel in 2001, along with two other economists, for his analysis of “markets with asymmetric information,” which, in his own words, involves cases in which “some individuals know something that others do not” … A general name for Stiglitz’s field is “information economics,” which—again, in his words—has “explored the extent to which markets and other institutions process and convey information.”

There is much to admire in his work on asymmetric information.  Unfortunately, he and the other Economists involved in Information Economics only recognize three of the four quadrants of the Information Matrix.  And this is a huge on-going mistake.  It is the fourth quadrant that is critically important because it is the quadrant financial crises emerge from.

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

In case you don’t believe me, let me explain why this is true in terms a six year-old could understand.  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 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 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 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 paper bag has $0 in it.

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

I think we can agree that as soon as I started telling a story suggesting there might be less then $10 in the paper bag, there was no way to dismiss this story or actually value the contents of the paper bag.

I think we can also agree some people will think there is still $10 in the paper bag and others will think there is $0 in the paper bag.

Finally, we can also agree the people who think there is $0 in the paper bag would be happy to “sell” the contents of the paper bag to those who think there is $10 in the bag for $5.  And the people who think there is $10 in the paper bag would be happy to “buy” the contents of the paper bag for $5.

In this example, both buyer and seller are blindly betting based on a story.  Neither knows what is in the paper bag.

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 also 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.  If the presence of opaque securities is sufficiently large, the result of this run is a financial crisis.

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.

Please note, the Information Matrix seamlessly integrates Standard and Behavioral Economics. Standard Economics provides insight into why people would Verify the story Wall Street tells (it is rational to do so).  Behavioral Economics provides insight into why people Trust, why they like stories and why they would panic when they fear losing all of their investment.

So what is the right response to a financial crisis?

Pursuing the Swedish Model and bringing transparency to the opaque areas of the financial system.

In the Great Financial Crisis that began in 2007, this would have meant bringing transparency to the opaque banks and subprime mortgage-backed securities.  Naturally, this would have resulted in exposing a lot of debt the borrowers could not repay (after all we know there were 9 million home foreclosures).  This debt should have been written down to the greater of a borrower’s capacity to repay or what an independent third party would pay for the collateral.

But wouldn’t requiring the banks to take losses make them insolvent?  They were already insolvent as the bad assets were already on their books.  Hiding their insolvency behind a veil of opacity and not making the banks recognize the losses didn’t change the fact.

But wouldn’t making the banks take losses require the government to nationalize them immediately?  No.  Due to the combination of deposit insurance and a central bank lender of last resort an insolvent bank can continue in operation supporting the real economy until such time as the regulators chose to close it.  As shown by the US Savings & Loans in the 1980s, this time could be years into the future.

Professor Stiglitz and the Economics profession compounded the mistake of not recognizing the existence of the Blind Betting quadrant by opening their mouths and offering their opinion on how to respond to the crisis.  They were long on promoting fiscal stimulus and monetary accommodation and much shorter on the need to write down the bad debt.  They did succeed however at effectively drowning out the call for restoring transparency.

They also offered up their view on how future financial crises could be prevented.

Stiglitz’s proposal for how future meltdowns can be prevented: empower incorruptible regulators, smart enough to do the right thing.

The Dodd-Frank Act is a monument to making the global financial system dependent on regulators.  But is there any reason to think these regulators can prevent a financial crisis from emerging from the Blind Betting quadrant?

No!

Why?  Transparency was never restored to the opaque corners of the global financial system from which the Great Financial Crisis emerged in 2007 and other opaque corners have grown substantially as a result of the response to save the banks.

Finally,

In his Nobel lecture, Stiglitz spoke of having “undermined” the free-market theories of Adam Smith, asserting that Smith’s “invisible hand” either didn’t exist or had grown “palsied.”

Like Professor Stiglitz, I too have “undermined” the existing theories embraced by the Economics profession with the expansion of Information Economics to include the Blind Betting quadrant.

Unlike Professor Stiglitz, my expansion lets everyone understand where financial crises come from, why the financial system is designed the way it is and how a financial crisis should be responded to.