As the title of this post suggests, there are many mistaken assumptions about the financial crisis still in circulation.  No mistaken assumption is more critical than the 2008 start date for the crisis.  Why?  Because the start date for the crisis contributes directly to the narrative you tell about the crisis.

The Great Financial Crisis actually started on August 9, 2007 when BNP Paribas announced it couldn’t value the opaque mortgage-backed securities in funds it was managing.  The impact was immediate as the opaque sectors of the global financial markets began to lock up.  For example, spreads increased in the interbank lending market.  [I know some would like to argue it started in March 2007 when HSBC wrote off a significant chunk of its investment in Household Finance, but this had very limited impact on the financial markets beyond HSBC.]

By starting on August 9, 2007, the narrative about the Great Financial Crisis is it was an earthquake along the opacity fault line in the global financial system.

But what happens if you choose the fall of 2008 as your start date for the financial crisis?

Fortunately for us, Nicola Gennaioli and Andrei Shleifer in their book, A Crisis of Beliefs:  Investor Psychology and Financial Fragility, provide a narrative of the financial crisis with this later start date.  As Brad DeLong summarizes their narrative:

Ben Bernanke, then Chair of the US Federal Reserve, seemed confident in the summer of 2008 that the correction in housing prices had not triggered any unmanageable financial crisis. At the time, he was mainly focused on the dangers of rising inflation.

And then the bottom fell out. The reason, Gennaioli and Shleifer show, is that beliefs changed. Investors came to believe that financial markets were saddled with highly elevated risk, owing to a number of factors. The interbank market had seized up, homeowners were defaulting on their mortgages, Bear Stearns had collapsed, the US Treasury had intervened to rein in Freddie Mac and Fannie Mae, and, above all, Lehman Brothers had declared bankruptcy.

All of this led to the sudden run on both the shadow and non-shadow banking systems, as investors scrambled to dump assets. The increased risk that they had imputed to the system became a reality. Like triage nurses in an emergency room, they quickly assessed the patient and then ran with their initial diagnosis as if there were no other option.

I like the expression “beliefs changed” to describe why investors engaged in a classic financial panic.  It indicates to me the authors would have embraced the opacity earthquake narrative had they started their analysis from the time the crisis actually started.

Instead, they started their analysis with the acute phase of the Great Financial Crisis.  This creates problems with their narrative.

For example, why did the interbank market seize up before the fall of 2008?  This can be easily answered with the opacity narrative.  The banks with money to lend refused to lend to the banks looking to borrow because there was no way of assessing if the opaque borrowing banks could repay the loan.  What is the authors’ response?  There was a belief change.  Ok, when did this occur?  [hint: August 9, 2007].

For example, what did the initial diagnosis based on a quick assessment reveal to investors that caused them to scramble to dump assets?  This can be easily answered with the opacity narrative.  The investors discovered they didn’t have the information they needed to know what they own.  Investors know in this situation they are better off trying to get their money back sooner rather than waiting.  Hence, the scramble to dump assets.  What is the authors’ response?  The investors found something that caused them to change their beliefs.  Not exactly a satisfactory answer.

Based on their book, I suspect the authors would be big supporters of the Information Matrix.  Particularly because the Information Matrix fills in the holes in their “belief change” narrative.

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

The Information Matrix explains the design of the global financial system and financial crises.

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

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

Keep in mind, behavioral economics’ 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 valuation story can be verified and in the Blind Betting quadrant the absence of the necessary information means the story can only be “believed” because it cannot be verified.

Whether the valuation 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.  Hence, the investors’ “beliefs change” about the valuation story.  Investors, as behavioral economics suggests, naturally panic.  The result is a “scramble to dump assets” to get their money back.

Professor DeLong inadvertently confirms the need for the Information Matrix.

Gennaioli and Shleifer’s second important contribution is to show that “crises of beliefs” like the one that precipitated the disaster of 2008-2009 are deeply rooted in human psychology, so much so that we will never be free of them. Thus, neither prudential policies nor crisis-response measures should treat these occurrences as flukes or one-off exceptions. Crises of belief are manifestations of a chronic condition that must be managed.

That chronic condition being opacity in the financial system.  It is only by reducing the level of opacity that financial crises can be prevented (see Transparency Label Initiative).

Finally, Professor DeLong calls for remaking Economics.

The third reason why Gennaioli and Shleifer’s book is important is more technical, and applies directly to the field of economics. Economists have long recognized that requiring one’s representative agent to hold rational expectations of the future tends to produce models that are profoundly inapplicable to the real world. But, until now, no alternative approach has ever gained any traction. Gennaioli and Shleifer’s investors-as-triage-nurses framework shows great promise for being considered alongside other model-building strategies.

Since the investors-as-triage-nurses framework is already embodied in the Information Matrix, Economists should work the Information Matrix into their model-building strategies.