Why has the Information Matrix Fallen on Deaf Ears?

Anyone determined to provide a “new economics” must haul a heavy burden of proof up a steep slope of professional resistance. At the summits of academic prestige, economics presents a Delphic façade of math and marble.

A still higher barrier faces anyone suggesting major modification to the entrenched system of reasonably free markets and economic incentives associated with “capitalism.” — George F. Gilder

Upton Sinclair described this higher barrier:

It is difficult to get a man to understand something, when his salary depends on his not understanding it.

These two quotes go a long way towards explaining why the Information Matrix has not been adopted by the Economics profession, financial regulators and policymakers to date. It has nothing to do with “is the Information Matrix right?”. It is¹. It has everything to do with institutional barriers that prevent adoption.

So the question becomes “what does it take to get over these institutional barriers?”.

Amazingly, the Great Financial Crisis was not enough to get over these institutional barriers.

Having failed to prevent the Great Financial Crisis, the financial regulators said give us more authority and we will prevent the next crisis. Under the Dodd-Frank Act, they were granted much more authority. If ever there was a sign this authority was much ado about nothing, it is the ongoing pursuit of many of the major policies adopted to address the acute phase of the crisis.

This is not surprising. Anyone who understood the Information Matrix in 2008 would have been like myself and said nobody would design a financial system to be dependent on regulators. There is ample evidence they are not up to the task of preventing another financial crisis.

Having failed to see the crisis coming, the Economics profession told us this failure wasn’t a problem as it knew what policies to adopt to restore a self-sustaining recovery. A decade plus later, their policies have not done so.

This is not surprising. Anyone who understood the Information Matrix in 2008 would have been like myself and said their policies not only wouldn’t work, but were so toxic they would undermine the real economy and society. By 2021, we unfortunately have tons of proof we were correct and the Economics profession was wrong again.

Still, the Information Matrix has not been adopted. What does it take?

1. The Information Matrix:

                                                 Information Matrix

                                                                   Does the Seller know what they are selling?

                                                                                  Yes                                No

Does the Buyer know what         Yes     Perfect Information     Antique Dealer Problem

they are buying?                            No      Lemon Problem            Imperfect Information

The Information Matrix shows imperfect information is THE market imperfection.  By definition, a buyer or seller has “imperfect information” when the information they have does not allow them to make a fully informed decision because the information is insufficient and/or incomplete.

In the financial markets, imperfect information takes the form of opacity.  In the presence of opacity, investors cannot assess the risk/return of an investment.  Without this assessment, investors don’t know what they own beyond what Wall Street tells them.  Policymakers in the 1930s focused on eliminating opacity by creating the SEC and making it responsible for ensuring investors had access to the information they need to know what they own.

Of course, this put the SEC directly at odds with Wall Street.

Wall Street understands it makes more money selling opaque, high margin products than it does selling transparent, low margin products.  This gives Wall Street an incentive to lobby the SEC for disclosure requirements that are insufficient for investors to know what they own.

Wall Street knows and behavioral economics has shown everyone likes a good story.  Wall Street firms deliberately creates opaque securities they can sell based on a good valuation story they tell.  The difference between the Perfect Information and Imperfect Information quadrant is in the Perfect Information quadrant buyers and sellers can Trust, but Verify this story.  In the Imperfect Information quadrant, buyers and sellers can only trust the story as opacity prevents their verifying if it is true or not. When doubts arise about an investment story that cannot be verified, investors run to get their money back (the classic “financial panic” we see during financial crises).