Recently, I politely referred to Ben Bernanke’s latest effort to rewrite the history of the Great Financial Crisis as garbage.  The paper is actually worse than that.  However, in fairness to Mr. Bernanke, his intended audience for the paper is the Priesthood of the MacroEconomics PhDs and not a deplorable like myself.  Let me try to explain why this difference in our focus leads to dramatically different views not only on the Great Financial Crisis and how it should have been responded to, but also on the need for a remake of economics.

He begins his paper by observing,

As I argued in a speech some years ago, the occurrence of a massive, and largely unanticipated, financial crisis might best be understood as a failure of economic engineering and economic management, rather than of economic science. I meant by that that our fundamental understanding of financial panics—which, after all, have occurred periodically around the world for hundreds of years—was not significantly changed by recent events.

I must confess I recently read Nobel prize winning Economist Paul Romer’s critique of the macroeconomics profession.  In his critique, Mr. Romer argues evidence [the facts] have become irrelevant to macroeconomists.  So irrelevant, he calls their models post real.  As in, the models have no connection to the real world.

Mr. Bernanke’s observation confirms Mr. Romer’s critique is true.  Mr. Bernanke says there is nothing significant to be learned about understanding financial panics from the Great Financial Crisis.

Wow!

He just rejected fundamentally rethinking the model used by macroeconomists to describe financial panics.  In 2008, the Queen of England asked at the London School of Economics why the Economics profession hadn’t seen the crisis coming.  Clearly, the model Mr. Bernanke feels doesn’t need a fundamental rethinking didn’t predict the financial panic, let alone result in the macroeconomics profession warning a financial crisis was coming.  Mr. Bernanke’s response confirms Mr. Romer’s observation macroeconomists have a tendency to disregard the possibility their theories might be wrong.

Mr. Bernanke then goes on to say

Rather, we learned from the crisis that our financial regulatory system and private-sector risk-management techniques had not kept up with changes in our complex, opaque, and globally integrated financial markets; and, in particular, that we had not adequately identified or understood the risk that a classic financial panic could arise in a historically novel institutional setting.

I appreciate Mr. Bernanke trying to shift the blame from shortcomings in macroeconomic models to someone else.

I also appreciate Mr. Bernanke learned it is impossible to understand risk in a “complex, opaque, and globally integrated financial” system.   Hmmm…. could it be opacity is the problem when it comes to understanding risk ….

As Mr. Romer pointed out, macroeconomists have a very large identification problem.  Mr. Bernanke showed this is true when it comes to a classic financial panic.  According to Mr. Bernanke, macroeconomists have no ability to take what they know about financial panics and use this knowledge to predict what will happen when confronted by new situations.

Why does this identification problem exist?

If you look at the seminal work on financial panics and bank runs done by Diamond and Dybvig, you discover making their model mathematically solvable required a number of assumptions.  The most important assumption from the perspective of using this model to predict or address financial panics and bank runs in the real world is the cause of financial panics and bank runs is outside of their model.  To paraphrase Mr. Romer, the D&D model is a post-real financial crisis model.  It does a wonderful job of modeling what happens after a financial panic starts, but provides no insights into what causes financial panics.  No wonder macroeconomists have a hard time applying this model in new situations.

Regular readers know my focus is on what causes financial panics and “bank runs”.  After all, if you don’t know the actual cause, there is no reason to think your policy response will address and fix the cause.

Let me try to show just how important this difference in focus is by looking at how opacity is treated.

When you look at what causes financial crises and “bank runs”, you discover opacity is the necessary condition for these to occur.  In the presence of opacity, investors cannot use the facts to dismiss a story their bank might be insolvent.  Hence, they have an incentive to run to get their money back should the story be true.

Including opacity requires remaking Economics.  Why?  You develop the Information Matrix.

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

It explains where financial crises come from (the Blind Betting quadrant when the valuation stories told about the opaque securities in this quadrant are called into doubt).  It explains how to respond to financial crises (use the banks to protect the real economy/borrowers by having banks absorb losses on excess debt rather than foreclosing on 9.3 million homeowners and/or creating zombie corporations).  It explains how to prevent financial crises (push as much of the financial system as possible into the Perfect Information quadrant where investors can Trust, but Verify the valuation stories).  It explains why our financial system is designed the way it is (the combination of deposit insurance and a lender of last resort makes the banks dependent on the country, but the country isn’t dependent on any of its existing banks; as a result, insolvent banks can operate indefinitely supporting the real economy until the regulators close them).  It seamlessly integrates standard economics and behavioral economics.

And it allows you to reject as BS many flawed notions pushed by members of the Priesthood of the PhDs.

When you focus on post-real financial crisis models, like Mr. Bernanke does, you free yourself up from having to deal with inconvenient real world facts like opacity.  It lets you buy into the most wonderful delusional fantasies without having to take any drugs.  Here is the fantasy Mr. Bernanke has cited numerous times as the critical insight he used to inform the financial crisis policy response he lead:

An approach which seems particularly useful for understanding the recent crisis, and which fits nicely with the idea of a variable external finance premium, comes from Gary Gorton and coauthors (Gorton and Pennachi, 1990; Dang, Gorton, and Holmstrom, 2015). In the Gorton setup, intermediaries meet a substantial part of their financing needs by issuing “information-insensitive” liabilities, that is, liabilities structured in a way that makes their value constant over almost all states of the world. Besides demand deposits, examples of information-insensitive liabilities in modern finance include short-term, over-collateralized loans (e.g., many repo agreements), asset-backed commercial paper, shares in low-risk money-market mutual funds, and the most senior tranches of securities constructed from diverse underlying credits.

From the perspective of ultimate investors, the advantage of information-insensitive liabilities is that they can be held without incurring the costs of evaluating the individual credits that back those claims—a task at which most investors are at a comparative disadvantage—and without concern about principal-agent problems, adverse selection, and other costs that often arise in lender-borrower relationships. Moreover, information-insensitive liabilities will tend to be liquid, because potential buyers likewise do not have to incur high costs of evaluating them or worry about adverse selection among sellers. Consequently, investors who face unpredictable needs for liquidity (as in Diamond-Dybvig’s setup) will benefit from holding such claims. Investor risk and transaction costs are reduced further when the information-insensitive liabilities have short maturities, since rather than selling the assets when liquidity is needed, investors can simply stop rolling over their claims as they mature. From the issuer’s point of view, the benefitof information-insensitive liabilities is their lower required yield and their attractiveness to broad classes of investors. Much of the financial innovation of the pre-crisis period reflected issuer efforts to create information-insensitive liabilities from risky underlying assets.

Panics emerge in this setup when, as the result of unexpected events or news, investors begin to worry that the intermediary liabilities are not money-good, that is, their liabilities are no longer information-insensitive. Investors continuing to hold these claims face the unattractive alternatives of either making independent evaluations of the underlying credits—which they are not well equipped to do—or bearing the costs of uncertainty, illiquidity, and adverse selection. If the claims are contractually short-term in nature, many investors will decide not to roll them over, resulting in a panic.

When you are as comfortable operating with post-real financial crisis models as Mr. Bernanke is, the idea an investment can be “information-insensitive” one moment and as a result of news be “no longer information-insensitive” the next is not at all hard to embrace.  To the rest of us, this looks like pure BS.

Let me offer a simpler, more accurate explanation:  these investments were always information sensitive.  After all, news is information.  Since these investments are short-term, there is no reason to think investors would react to most news, particularly good news.  Their investment is not going to become more valuable.  On the other hand, there is plenty of reason to think investors would react to bad news.  Their investment could become dramatically less valuable.

So why did the investors panic?  These “information-insensitive” investments were actually opaque.  In the presence of bad news and the absence of facts, panic came naturally.  [By the way, behavioral economics explains how investors came to buy these opaque securities in the first place:  investors like a good story.]

While I could go on debunking Mr. Bernanke’s paper, suffice it to say the paper only confirms how truly awful and inappropriate were the protect the bank policies he pursued in response to the acute phase of the Great Financial Crisis.