A key feature of financial crises is the flight to low risk assets.  Scholars see this flight as the transmission mechanism that turns a financial crisis into an economic crisis.  Why?  Because it typically involves money being withdrawn from the banking system and parked in government securities.  With their funding base shrinking, banks in turn make fewer loans.  The reduction in lending leads to a reduction in economic activity.

Left unanswered by scholars is why this flight to low risk assets occurs in the first place and what type of assets do investors flee from.  Without the answer to these questions, it is impossible to prevent this flight to safety and the damage it does to the economy.

Fortunately, the Information Matrix allows us to answer both questions and to understand what must be done to prevent future flights to safety.

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

To answer these questions, we need a physical security model.  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, a six year-old would say both bags have a $10 bill inside.

Next, I 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 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.  Please note, my story is completely irrelevant to how the six year-old values the content of the clear plastic bag.  He can see its value doesn’t change.  This is very important.  It shows in the presence of transparency until the facts change its value doesn’t change.  And when the facts change, there is a logical stopping point in any potential decline in value.

So I 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 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 $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 securities that are valued based solely on stories that cannot be verified are the source of the flight to low risk assets we observe in financial crises.  I have also illustrated the asset of choice to run to is an asset in the Perfect Information quadrant.

In addition, I have shown how to prevent this flight in the first place.  This is accomplished by ensuring transparency so investors have the information they need to know what they own.