The answer to the Queen's Question

According to a Financial Times column, in the fall of 2008, the Queen of England put the economics profession and global financial policy makers and regulators on the spot with a simple question.  At the London School of Economics she asked, "if things were so large, how come everyone missed them?"

Regular readers know the answer lies in the failure to provide market participants with all the useful, relevant information in an appropriate, timely manner as required under the FDR Framework.

They also know that your humble blogger was among the handful that did not miss what was happening and said before the crisis began that the impact of the crisis could be moderated with disclosure.  Since the solvency crisis began in 2007 and has not ended, just ask the Europeans, the prescription for disclosure is still in effect.

The Queen's Question is not why did no-one predict that Lehman Brothers would collapse in September 2008.  She knows that firms have failed in the past without threatening to bring down the entire global financial system.

She was asking how could the economics profession and global financial policy makers and regulators have missed what was happening that created the conditions under which the global financial system faced the prospects of collapse.

Three years later, the Queen could return to the London School of Economics and point out that the same economics profession and global financial policy makers and regulators that missed it heading into the crisis have had the chance to apply their best ideas without fixing the problem [for those who suggest that the problem has been fixed, please see the issue of solvency swirling around Bank of America and the European banks].

She might ask given the abysmal track record of the economics profession and the global financial policy makers and regulators with regard to this financial crisis, is there anyone with a public track record of predicting the financial crisis, predicting which policy initiatives will or won't work and who is offering a solution that has been shown to work in the capital markets.

At a minimum, I look forward to my conversation with the Queen.

It’s a reasonable question – and one to which you evidently haven’t had a satisfactory answer during your weekly visits from that man who comes to tell you what is going on....
All in all, that’s not surprising. The grumpy one has desperately been trying to give the impression that the crisis suddenly and inexplicably pitched up in Europe from New York, like a confused migrant trying to buck the historical trend. 

If I were you, Ma’am, I’d raise a regal eyebrow in polite scepticism at that one. The truth is that lots of people in lots of different countries simultaneously made the same mistake. The explanation you got from the man from the LSE was a pretty good summary. “At every stage,” Prof Garicano apparently replied, “someone was relying on somebody else and everyone thought they were doing the right thing.” 

Actually, it was not at every stage.  Regulators had access to all the useful, relevant information that they needed and they did not assess the risk properly.  Since regulators have an information monopoly when it comes to financial institutions, market participants have to rely on them.  The regulators' information monopoly is a point of instability in the financial system because when they under-estimate risk, market participants over-allocate capital.

A second point of instability in the financial system is the reliance on regulators to ensure that all useful, relevant information is disclosed in an appropriate, timely manner.

That is at least half right. House buyers took the view that as long as someone was prepared to lend them money, things would be OK. The mortgage lenders reckoned that as long as they could package up the mortgages as newfangled financial derivatives (it’s a long story, Ma’am) and sell them on, that would be fine.  

This excuse overlooks their economic incentives as their pay was based on creating these derivatives.

The financial institutions surmised that as long as the credit ratings agencies were giving the derivatives their seal of approval, everything would be dandy.

With the lack of transparency into the underlying mortgages, it was impossible to trust, but verify.  So instead, they relied on the credit rating agencies.  The rating agencies were purported to have a business model based on having access to data that was not available to other market participants.

It was not until the fall of 2007 that the credit rating agencies announced that they did not have any different access to information on structured finance securities than the investors.

 The credit ratings agencies thought – actually, it is pretty hard to work out what in God’s name the credit ratings agencies were thinking, except that as long as their rivals were giving these assets the thumbs-up, they had better do so as well.  As for the regulators, Ma’am, the point is that they didn’t really know and too many didn’t want to.

... Warren Buffett, a somewhat well-known investor from one of your revolted colonies, called these exotic derivatives “weapons of mass destruction”.  Actually, the comparison is apter than even Mr Buffett might have thought. The main thing about these derivatives is no one knew how big the stockpiles were, who had them, or what exact form they took. 

Nor did people know enough about how much they were really worth.

Amazingly, three years later and market participants still do not have answer to these questions.

To extend the Iraq war analogy, the smarter economists treated this as a known unknown. They knew that they didn’t know, and they knew that they wanted to know. But the politicians and regulators whose job it was to know, it appears, didn’t want to know, or didn’t want to know badly enough. They are now pretending it was an unknown unknown. Don’t believe them. 

How did they get away with it? Partly because there were always some tame economists on hand to say that everything was fine. Economists are supposed to be scientists, albeit of the social variety. It gets dangerous when you start treating them as court necromancers, selectively listening only to the ones whose views you find congenial. And at each point, it wasn’t in the politicians’ interests to poke around too much. 

Look at it from the perspective of your own dear government .... when you asked that nice smooth man to form a government for you and he politely obliged, the economy was growing merrily. House prices were rising. People were feeling richer and taking out more loans. (God might save, our gracious Queen, but your subjects are better at borrowing.) Banks were creating lots of jobs. The golden eggs, both economic and electoral, kept tumbling into your government’s lap. It would have taken a brave minister to go anywhere near the goose, particularly when it was being fiercely guarded by a dour Scotsman with a giant clunking fist and a truly divine talent for hand-to-hand infighting. As for the banks themselves, they were supposed in essence to take out proper insurance against everything going wrong. But they didn’t, and the taxpayer ended up footing the bill.

So there you have it. Why didn’t people see it coming? Some did, Ma’am. Some did. But it doesn’t mean they were listened to.

Or that they are being listened to today.

And there is a long history of people in authority running up vast debts without public accountability...

This lack of accountability underscores why global financial policy makers, regulators and central bankers have not solved the problem in three years.  The solution is to adopt the FDR Framework, release the information to all market participants and restore public accountability.