Misunderstanding Financial Crises: Why We Don’t See Them Coming
Before 2007, economists thought that financial crises would never happen again in the United States, that such upheavals were a thing of the past. In this book I argue that economists fundamentally misunderstand what financial crises are, why they occur, and why there were none in the U.S. from 1934 to 2007. Economists looked from a certain point of view and missed everything that was important: the evolution of capital markets and the banking system, the existence of new financial instruments, and the size of certain money markets like the sale and repurchase market. How could that have happened?
Misunderstanding Financial Crises offers an overview of financial crises, and shows that they are not rare, idiosyncratic events caused by a perfect storm of unconnected factors. I show how financial crises are inherent to our financial system. Comparing the so-called “Quiet Period” of 1934 to 2007, when there were no systemic crises, to the “Panic of 2007-2008,” I try to tie together key issues like bank debt and liquidity, credit booms and manias, moral hazard, and too-big-too-fail–all to illustrate the true causes of financial collapse. I argue that the successful regulation that prevented crises since 1934 did not adequately keep pace with innovation in the financial sector, due in part to the misunderstandings of economists, who assured regulators that all was well. I also look forward to try to offer both a better way for economists to think about markets and a description of the regulation necessary to address the future threat of financial disaster.
Slapped by the Invisible Hand: The Panic of 2007
Since the financial crisis began in 2007, economists, government commissions, and the public at large have been consumed by the same question: What happened? In his new book, Slapped by the Invisible Hand: The Panic of 2007 (Oxford University Press), Professor Gary Gorton explains that the root cause of the current crisis, like many systemic crises before it, was a banking panic.
Gorton has observed the current crisis from a unique vantage point. For the last 25 years, he has spent his academic career focused on banking, financial crises, and banking panics. As a PhD candidate, Gorton wrote his 1983 dissertation on banking panics. “When I wrote it, I never dreamed I would live through one,” he says.
As Gorton points out, banking panics have happened throughout history. Although long forgotten by many, panic episodes occurred in 1873, 1884, 1890, 1893, 1896, 1907, and 1914. “Financial crises have been the norm in U.S. financial history,” he explains.
He also notes that from 1934 to 2007, the U.S. banking system was panic-free. This Quiet Period, as Gorton calls it, was brought on by a combination of the government deposit insurance enacted in 1934 and regulation. Banking panics were assumed to be a thing of the past, says Gorton, but in the last 25 years the banking system evolved to include the shadow banking system, and like traditional banking, it is vulnerable to runs. It was in the shadow banking system that the Panic of 2007 originated.
Gorton explains that the shadow banking system, which allows institutional investors and firms to make very large short-term deposits backed by collateral, is a genuine banking system that is as large as the traditional, regulated banking system, and it experienced a system-wide panic. Unlike earlier banking panics in history where depositors ran to their banks to withdraw money from their accounts, the shadow banking system experienced a run in the short-term sale and repurchase (“repo”) market. Financial firms ran on other financial firms.
In many respects this wholesale bank run was similar to the retail banks runs of the past, says Gorton, except that it was invisible to nearly everyone, happening out of sight in markets that most people had never heard of, which only added to the confusion and anxiety about why the crisis had happened. “Without observing the bank run, what became visible were only the effects of the run and, in many cases, the effects were mistaken for the cause. Without the details of what happened, new policies may end up addressing effects rather than the cause,” he says.
The details of what happened are Gorton’s focus in his Slapped by the Invisible Hand. He outlines the complex securities, structures, and markets underlying the crisis, explaining the intricacies of how the subprime housing market was the shock that set off the bank run in the repo market that ultimately caused the crisis. Gorton also discusses the crisis within the context of U.S. financial and banking history. The book is based around three previously published papers: two that were written during the crisis for Federal Reserve conferences in April 2008 and May 2009, and another written in the 1990s when it became clear to Gorton that what is now called the shadow banking system was developing and would pose a challenge for bank regulation. Each paper is Gorton’s record of a particular moment, and as a collection they capture both the events and the zeitgeist of this period in our financial history.
Providing an accurate narrative of the crisis is critical, says Gorton. Only by understanding that the crisis was caused by a banking panic can the proper reform measures and regulation be put in place to bring about another Quiet Period in banking. “Retuning the system depends on the narrative of the crisis, which sets the framework for new regulations. There is a lot at stake,” says Gorton.