While still the Fed chair, Janet Yellen gave an interesting speech  on October 14, 2016 in which she pointed out when it comes to financial crises Economists are like Sargent Schultz of Hogan’s Heroes:  they know nothing.

Or as she phrased it at the start of her speech,

Extreme economic events have often challenged existing views of how the economy works and exposed shortcomings in the collective knowledge of economists. … Today I would like to reflect on some ways in which the events of the past few years have revealed limits in economists’ understanding of the economy and suggest several important questions I hope the profession will try to answer.

Please re-read her comment about the existence of “shortcomings in the collective knowledge of economists” and “revealed limits in economists’ understanding of the economy” when we have a financial crisis.

This speech was given at the end of 2016 or roughly 8 years after the banking crash of 2008.  Yet, here is the chair of the Federal Reserve pointing out the shortcomings and limits to economists’ knowledge about financial crises still exist and haven’t been addressed.

She demonstrates where these shortcomings and limits to economists’ knowledge exist when it comes to the financial sector.

How does the financial sector interact with the broader economy?

In light of the housing bubble and subsequent events, policymakers clearly need to better understand what kinds of developments contribute to financial crises. What is the relationship between the buildup of excessive leverage and the value of real estate and other types of collateral, and what factors impede or facilitate the deleveraging process that follows? Does the economic fallout from a financial crisis depend on the particulars of the crisis, such as whether it involves widespread damage to household balance sheets? How does the nature and degree of the interconnections between financial firms affect the propagation and amplification of stress through the financial system and overall economy? Finally–and most importantly–what can monetary policy and financial oversight do to reduce the frequency and severity of future crises?

At this point, regular readers are probably saying to themselves, haven’t these PhD economists and central bankers ever heard of the Information Matrix.  The Information Matrix has been available for years and provides answers to all of Yellen’s questions.

Let me assure you, it isn’t because I haven’t talked about it and shown it to them.

I have talked to academic PhD economists in both Economic departments and business school Finance departments.  A subset of the places they work includes Harvard, MIT, Yale, Princeton, Columbia, Dartmouth, Chicago, Stanford, Berkeley, Michigan, Boston College, NYU, Northeastern, Brandeis, the London School of Economics and Victoria University of Wellington.

I have talked to central bankers, including many with a PhD in Economics, at the Bank of England, the European Central Bank and the Federal Reserve.  In addition, I have talked with PhD economists at international agencies like the IMF and OECD.

The one thing they all have in common is unlike a six year-old who has been shown the Information Matrix, they still do not understand how our financial system is designed and how it is suppose to be used to protect the real economy in the event of a financial crisis.

Is this failure to understand a function of their priors (the assumptions they make about how the economy works)?  Is this failure to understand a function of their ongoing defense of their PhD thesis?  Is this failure to understand a function of a lack of mathematical razzle-dazzle?  Is this failure to understand a function of not invented here syndrome?  Or is this failure to understand just a reflection of Upton Sinclair’s observation:  it is difficult to get a man to understand something when his salary depends upon his not understanding it”?  One can only speculate.

So let me try one more time to explain the Information Matrix (and then answer Yellen’s questions).  The starting point is a famous expression often attributed to Einstein:

If you can’t explain it to a six year old, you don’t understand it yourself.

For those of us who do understand the financial crisis, there is no reason not to explain it in terms a six year-old could understand.  And to do this we need a physical model including two securities.  Representing a transparent security we will use a clear plastic bag with a $10 bill inside.  Representing an opaque security we will use a brown paper bag which I initially also put a $10 bill inside.

When asked how much is in each bag, the six year-old would say both bags have a $10 bill inside.

Next, I will 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 will 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 brown paper bag has $7.

So I will continue my story and tell him while eating the bagels, I was thirsty.  So I bought myself an orange juice to drink.  The juice cost $3 dollars.

Once again, I will 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 brown 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 brown paper bag has $0 in it.

Well reader, how much is in the brown paper bag?  Is it still the initial $10 (after all, I didn’t say I used the money in the brown paper bag to pay for what I ate or drank)?  Or is it it $0?

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 where both buyer and seller have the clear plastic bag view of the contents of the bag.  Not surprisingly, this is the quadrant a six year-old would choose too.

It is also the quadrant the designers of our financial system attempt to make all transactions occur in.  Why?  Because investors can Trust, but Verify the story they are told about the investment.  It is also the quadrant where the market can exert market discipline.

Unfortunately, transactions occur in the Blind Betting quadrant.  As Wall Street knows, everyone likes a good story.  Wall Street goes Phishing for Phools who will buy the investment without verifying the story.

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.

What I have just done is illustrate how our financial system is designed to work and how securities that are valued based solely on stories that cannot be verified are the source of financial crises.  And I did it in such a way a six year-old can easily understand it.

Now to Yellen’s questions.

What type of developments contribute to financial crises?

The growth in the amount of opaque securities in the global financial system.  The existence of a critical mass of these securities is the necessary condition for a financial crisis to occur.  As the six year-old showed, in the absence of opaque securities, financial crises don’t occur.

What factors into the build-up of excessive leverage?

Opacity.  It allows Wall Street to sell securities that hide the risk of the underlying leverage.

What factors impede or facilitate the deleveraging process?

Financial regulators and central bankers impede or facilitate deleveraging.  They impede deleveraging when they engage in regulatory forbearance (see growth in zombie borrowers) or reduce interest rates.

Does the economic fallout of the crisis depend on the particulars of the crisis?

No!  It depends on the particulars of the response to the crisis.

Specifically, do the financial regulators and policymakers use the banking system as it is designed to protect the real economy or not.  In 2008, in the EU, UK and US, they chose to save the banks and prevented deleveraging.  This put the burden of the excess debt in the financial system onto the real economy and guaranteed economic malaise.  Iceland chose to save the real economy and deleveraged by making its banks take losses on all the excess debt in the financial system.  A decade later, it is the EU, UK and US economies that are still struggling with the financial crisis.

How does the nature and degree of interconnections between financial firms affect…?

Contagion is a banker friendly narrative that only exists in the presence of opacity.

Investors know in exchange for disclosure of the information they need to know what they own they are responsible for losses on their investment exposures.  As a result, investors have an incentive to assess the risk of any investment and only have as much exposure as they can afford to lose.  This goes for both investors in the banks and the banks when they make an “investment” in another bank (think interbank loans or derivatives).  Transparency makes exposure management possible and the presence of exposure management ends contagion.

Finally–and most importantly–what can monetary policy and financial oversight do to reduce the frequency and severity of future crises?

Assure transparency!!!!

There is no reason a central bank should ever accept as collateral or invest in a security that doesn’t provide disclosure so a buyer can know what they own.  Investing in or accepting opaque securities as collateral is simply betting with taxpayer funds.

So how should central banks know if a security is transparent?

They should be clients of the Transparency Label Initiative.  If a security has the Initiative’s label, central banks know it is transparent and provides the necessary disclosure so a buyer can know what they own.  If it doesn’t have a label, central banks shouldn’t invest in it or accept it as collateral.

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In my inbox was a link to an article by Olivier Blanchard and Larry Summers that was directly relevant to this post.  As these know-nothings put it:

The changes in macroeconomic thinking prompted by the Great Depression and the Great Inflation of the 1970s were much more dramatic than have yet occurred in response to the events of the last decade.

First, this confirms Yellen’s observation economists know nothing about financial crises is still true in 2019.

Second, when you only look at what PhD Economists have done, this is true.  But if you actually look at the Information Matrix, you see it is very dramatic.  The Information Matrix integrates standard and behavioral economics.  It integrates the design of the financial system into economics.  It shows all the theories touted by finance departments only work in the Perfect Information quadrant.  It shows how to respond to financial crises.  It has a few more benefits, but you get the idea.