In 2008, the Queen of England asked the Economics profession why it hadn’t seen the Great Financial Crisis coming.  Like the Queen of England, I too don’t understand why the Economics profession cannot see and warn about both the financial and social crises that will likely result from implementing the policies it promotes.  Is it really asking too much of the Economics profession to know the second and third order consequences triggered by these policies?

Based on my experiences dealing with macroeconomists over the last decade, the answer is it really is asking too much.

Why?

I have yet to meet the macroeconomist who doesn’t think whatever comes out of his or her mouth when talking about the global financial system or economy is brilliant.  Or at least beyond questioning by anyone who isn’t a card carrying member of the priesthood of the Economic PhDs.

Of course, this is not remotely true.

If you point out the utter lack of brilliance of many of their utterances, they go into troll mode.  A classic example of this was provided by Princeton’s Atif Milan.

You have clearly not read the policy brief. Neither do you seem familiar with our work in the past. Please read before making sweeping statements.

1:14 PM – 16 Feb 2019

Having read his book, House of Debt, I can assure you I am familiar with his past work.  In my opinion, the book does a terrific job of looking at the implications for economic growth when there is too much debt and questions the response to the financial crisis.  Unfortunately, the book leaves unanswered the most important question.  Given the Great Depression policymakers took steps to ensure it would never happen again, what changed in the global financial system so we ended up with too much debt again?

Ultimately, answering this question requires understanding how the policymakers redesigned the financial system in the 1930s and what safeguards they put in place.  It also requires looking at the modern financial system and understanding how Wall Street defeated these safeguards.

The fact Professor Milan and his co-author did not answer any of these question suggests they do not have a basic understanding of how our financial system works. (I prefer not to speculate on why they don’t have this basic understanding as the likely candidates include a lack of training, intellectual laziness or knowing the bar is set so low even flawed research on the relationship between debt and GNP by Harvard’s Ken Rogoff is published in the best Economic journals.)

Had Professor Milan and his co-author taken the time to answer the question of how could this happen again, there is some chance they would have discovered the Blind Betting quadrant of the Information Matrix.  It is this quadrant that explains where financial crises come from, how we ended up with too much debt again and how policymakers were able to respond to the financial crisis the way they did.

Perhaps more surprising to me, is the fact Economists are willing to continue opening their mouth on a topic even when a subject matter expert tells them they are wrong.  it appears once they have reached a conclusion, they hold to this conclusion no matter how much evidence to the contrary or who is providing the evidence.

A classic example of this has been the Economics profession calling for higher bank capital requirements.  Few of these PhDs have ever worked for a bank.  Almost none of them have worked in the capital management area of a Too Big to Fail bank or lobbied for bank capital regulations (I would say none, but I haven’t seen the background of every PhD championing higher bank capital requirements).  In short, they lack real world subject matter expertise.

What they do have is an idea that works in theory and a willingness to travel the globe attending conferences presenting this idea.

Of course, there are bank capital subject matter experts who might point out why the idea doesn’t work in practice.  You might think my background working in the capital management area of a Too Big to Fail bank and helping to lobby for what ultimately became the Basel I capital requirements (the forerunner of what are now the Basel III capital requirements) qualifies me as an expert.

I pointed out why this call for higher bank capital requirements was at best a distraction and at worst a gift to the Too Big to Fail banks.

Why?

For bank capital to deliver any of the benefits these PhDs said it could provide requires transparency.  Otherwise, history showed bank regulators would never require banks to take losses during a crisis for fear of making the crisis worse.

During the GFC crisis, the bank regulators showed bank capital is an easily manipulated, meaningless accounting construct.  It was so easy to manipulate, the bank regulators did it.  Who can forget capital boosting measures like suspension of mark-to-market on subprime securities or approving “pretend and extend”  so banks didn’t have to write down all the debt borrowers could never repay.

Transparency is needed to exert discipline on bank regulators to use bank capital to absorb losses.  When there is disclosure, the market can see through their schemes.

Did the Economists calling for higher bank capital tell their audiences transparency was needed to make bank capital effective in practice?  No.

Did the Economists calling for higher bank capital tell their audiences without transparency, the problem of Too Big to Fail banks wasn’t addressed?  No.

These Economists were a gift to the Too Big to Fail banks.  By not talking about the need for transparency, they managed to suggest bank capital wasn’t what subject matter experts called an easily manipulated, meaningless accounting construct, but was actually meaningful.  And all of us were harmed by this.

Yes, bank capital requirements are higher.  But there is no transparency, so taxpayers are still on the hook for bailing out the Too Big to Fail banks.  An example of an obvious second order consequence from following their policy recommendations.