Economist Brad DeLong looked for the source of the next significant economic downturn and shows just how close an economist can get to discovering opacity in the financial system without making the discovery.  Of course, by not discovering opacity, he misses financial crises originate in the opaque sectors of the financial system.

That he didn’t discover opacity isn’t surprising.  After all, he blocked me on Twitter shortly after I pointed out the Information Matrix does a better job of explaining the Great Financial Crisis than the Economics profession’s narrative and it does so without leaving out inconvenient facts.  But I digress.

According to Professor DeLong,

the culprit will probably be a sudden, sharp “flight to safety” following the revelation of a fundamental weakness in financial markets. That, after all, is the pattern that has been generating downturns since at least 1825, when England’s canal-stock boom collapsed.

Needless to say, the particular nature and form of the next financial shock will be unanticipated. Investors, speculators, and financial institutions are generally hedged against the foreseeable shocks, but there will always be other contingencies that have been missed.

Sounds remarkably like what I have said happens when investors come to doubt Wall Street’s valuation story for securities in the Blind Betting quadrant of the Information Matrix.  There is the equivalent of a bank run that accompanies the “flight to safety” as investors try to sell the Blind Betting quadrant securities and purchase securities in the Perfect Information quadrant.

Of course, the financial shock is unanticipated and the other contingencies missed by financial market participants.  Why?  Because financial market participants cannot see the risk building up in the Blind Betting quadrant securities.  Hence, they cannot do anything to hedge against the shock.

It is also important to note under Professor DeLong’s narrative the next significant economic downturn is unavoidable.  The Information Matrix shows it can be avoided.  The solution is to restore transparency and minimize the size of the opaque sectors of the financial system.

Regular readers have heard this before.

Information Matrix

People like a good story.  This is true whether the investment Wall Street is telling them the story about is in the Perfect Information quadrant or in the Blind Betting quadrant.

The key difference between investments in the two quadrants is in the Perfect Information quadrant investors can Trust, but Verify Wall Street’s story.  In the Blind Betting quadrant, opacity (the absence of the necessary information) prevents investors from being able to verify Wall Street’s story.

Whether the story can be verified or not results in a vastly different response when Wall Street’s story is called into doubt.

In the Perfect Information quadrant, the story can be verified and the doubt generated dismissed.

In the Blind Betting quadrant, the story cannot be verified.  Not only is the doubt generated not dismissed, but the logical follow-up question arises:  is the investment worth anything?  This too cannot be verified.  Investors recognize this and, as behavioral economics suggests, naturally panic.  The result is a classic bank “run” to get their money back.