It has taken over a decade since the Great Financial Crisis started, but macroeconomists have discovered what they knew for sure about using fiscal stimulus and monetary accommodation to end a financial crisis isn’t true.  There is now overwhelming evidence relying on fiscal stimulus or monetary accommodation or any combination of the two in response to a financial crisis does not result in a self-sustaining economic recovery.

The interesting question is why macroeconomists ever thought any amount of fiscal stimulus or monetary accommodation would result in a self-sustaining recovery.

While still the Fed chair, Janet Yellen gave a speech  on October 14, 2016 in which she pointed out

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 …

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 a little over 9 years after the Great Financial Crisis began on August 9, 2007.  Yet, here is the chair of the Federal Reserve pointing out the shortcomings and limits to economists’ knowledge about financial crises exist and haven’t been addressed.  That this is still true today for macroeconomists was confirmed in a May 2019 article by Olivier Blanchard and Larry Summers and the recent Jackson Hole Conference focused on “Challenges for Monetary Policy” (economics-speak for what the heck should monetary policy makers do when $17 trillion dollars of debt already has a negative yield and there is no self-sustaining recovery in sight).

If fiscal stimulus and monetary accommodation had ended the Great Financial Crisis and resulted in a self-sustaining recovery neither Yellen’s speech nor Blanchard and Summers’ article nor a conference focused on challenges would have been necessary.

Of course, the fact macroeconomists have shortcomings and don’t understand how the economy works doesn’t mean you regular reader or I have this same problem.

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 where the buyer’s and seller’s view of any security is represented by either the physical model’s plastic or paper bag security.

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:  Perfect Information, the Information Asymmetry Quadrants (Lemon Problem and Antique Dealer Problem); or Blind Betting.

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 also 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 security other than zero.  Hence, owners of these opaque securities have an incentive to “run” to try to get their money back as soon as the valuation story is called into doubt.

The Information Matrix shows 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.

The Great Financial Crisis occurred because Wall Street was able to capture the process by which the SEC set disclosure requirements.  As a result, a critical mass of opaque securities was sold into the global financial system.  When the value of these securities was called into doubt by BNP Paribas on August 9, 2007, we had a financial crisis along the opacity fault line.  In September 2008, the crisis reach the opaque banks and this resulted in the banking crash of 2008*.

Lead by macroeconomists, we have tried to fix an opacity problem using fiscal stimulus and monetary accommodation.  Macroeconomists have discovered this doesn’t work.  Now they are asking each other why it didn’t work.

The Information Matrix explains why macroeconomists were unsuccessful and their use of fiscal stimulus and monetary accommodation didn’t work.  The solution to an opacity problem is restoring transparency so a buyer can know what they own.  Neither fiscal nor monetary policy can do this.  All these policies can do is buy time so transparency can be restored.

The Information Matrix also shows the way to prevent a financial crisis is by ensuring transparency.  Wall Street has shown it can capture a governmental agency whose mission is to ensure disclosure so a buyer can know what they are buying.  In order to prevent another crisis, a different solution for ensuring transparency is needed.

This is where the Transparency Label Initiative comes in.  Unlike the SEC, Wall Street cannot capture it because the Initiative is an independent entity that works solely for investors including central banks (the buy-side).  It uses a label to distinguish between securities where an investor can know what they own and where they are blindly betting.

This label turns opacity into an asset class.  Each investor can choose how much or how little exposure they would like to the opacity asset class.  An asset class whose valuation story has to include the promise of a high enough return to compensate the investor for the high likelihood of losing their investment.

The Information Matrix has a few more benefits.  It 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.  I could go on, but you get the idea.

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*For the record, there was one macroeconomist who understood we had an opacity crisis.  In a series of October 2008 interviews (see here and here), Anna Schwartz criticized using monetary accommodation and fiscal stimulus to address what was an opacity problem.

The Fed has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is that [uncertainty] that the balance sheets of financial firms are credible.”

She also recognized how hard it would be to stop macroeconomists from supporting and pursing endless rounds of monetary accommodation and fiscal stimulus.

If I regret one thing, it’s that Milton Friedman isn’t alive to see what’s happening today. It’s like the only lesson the Federal Reserve took from the Great Depression was to flood the market with liquidity. Well, it isn’t working. Professor Friedman would have enough stature to get them to listen.

Please stop and consider when Anna Schwartz made her observation about needing someone of her co-author’s stature she was considered by macroeconomists to be THE Great Depression scholar.  Who better to comment on what was the appropriate policy response to the Great Financial Crisis?

Ms. Schwartz was right about the need for Milton Friedman’s stature.  She was ignored by the cult of the PhD macroeconomists.

Keep in mind, these are the same macroeconomists who pushed yields into negative territory and have ignored the Information Matrix too.