Misunderstanding Financial Crises

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Misunderstanding Financial Crises

by
Gary B. Gorton

general information | review summaries | our review | links | about the author

Title:	Misunderstanding Financial Crises
Author:	Gary B. Gorton
Genre:	Non-fiction
Written:	2012
Length:	237 pages
Availability:	Misunderstanding Financial Crises - US
	Misunderstanding Financial Crises - UK
	Misunderstanding Financial Crises - Canada
	Misunderstanding Financial Crises - India

Why We Don't See Them Coming

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Our Assessment:

A- : fascinating historical study; interesting perspective

See our review for fuller assessment.

Review Summaries
Source	Rating	Date	Reviewer
The Economist	.	1/12/2012

From the Reviews:

"Mr Gorton presses his case a little too enthusiastically. Inadequate capital certainly explained why many, if not all, financial institutions foundered in 2007 and 2008. Similarly, Fannie Mae and Freddie Mac could not have grown so big and leveraged without moral hazard. He may be right that the Dodd-Frank act does not deal adequately with the liquidity cause of crises, but his alternatives, such as a special new class of bank, seem impractical. (...) That said, his book is a refreshing and valuable account that should take its place among the essential reading of any student of crises." - The Economist

Please note that these ratings solely represent the complete review's biased interpretation and subjective opinion of the actual reviews and do not claim to accurately reflect or represent the views of the reviewers. Similarly the illustrative quotes chosen here are merely those the complete review subjectively believes represent the tenor and judgment of the review as a whole. We acknowledge (and remind and warn you) that they may, in fact, be entirely unrepresentative of the actual reviews by any other measure.

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The complete review's Review:

The catastrophic financial crisis of 2007-8 came as a surprise. Underlying contributing factors, such as the American housing bubble, led some to warn of possible serious consequences to the American economy but as far as the systemic crisis that actually hit ... well, as Gorton puts it, after the Great Depression and:

Prior to the financial crisis of 2007-8, economists thought that no such financial crisis could ever happen again in the United States. Economists thought that a crisis could not happen.

This was a complete failure of the imagination, but also of serious scholarship, and in Misunderstanding Financial Crises Gorton shows what was missed and suggests what economists should now be on the lookout for in the future.
This book is not a close analysis of the details of the recent (and lingering) financial crisis; rather, Gorton strips it down to the most fundamental, arguing that essentially one can sum up that:

A financial crisis is about bank debt; it occurs when market participants come to mistrust the value of bank debt.

       That, he argues, is also how this crisis must be seen -- while noting (as he suggests no one did) that the bank debt in question this time around was of a very different sort than that of previous crises.
       To make his point, he offers a fascinating historical overview and discussion of previous, mainly American, financial crises -- and the book is worth reading for this alone, since many readers may not be aware of how the American financial system has been shaped over the years, and what the consequences of the various changes have been. Before the Federal Reserve, before the National Bank Act (passed during the Civil War), banks issued their own notes; not surprisingly, panics and runs on banks (leading to their collapse) were not infrequent -- if customers began to doubt their banks' worthiness it led fairly quickly and easily to the self-fulfilling prophecy of collapse. Once currency was backed by the government (in the form of U.S.Treasury bonds), consumers tended to feel somewhat more secure -- but doubts about banks themselves could still lead to panics and runs. Finally, the institution of federal deposit insurance during the Great Depression led to a feeling of greater security and hence also confidence, making panics and runs extremely rare.
       As Gorton notes, the reforms of the Great Depression led to what he terms a 'Quiet Period' -- the post-Depression-era stage of calm, essentially free of concern about systemic crises, that, it turns out, was finite, rather than (as previously believed) permanent. The balance during this Quiet Period, in which bank(er)s were assured of their easy, steady flow of income and risked little and consumers were able to trust their money was entirely safe in a bank's hands, was one that made for the stability everyone got all too used to. Unnoticed, Gorton argues, was how the banks' charter-monopoly (which insured their steady, easy income) was being eroded, a process that began accelerating in the 1980s. Increasingly, new players entered the field(s), with a far greater variety of financial instruments suddenly significant in the functioning of the economy -- and that made for a whole new ball game. Unfortunately, as Gorton notes, the rules were not adjusted over time, and so a system oriented towards reassuring bank-depositors was ill-equipped to offer similar safeguards for this reshaped financial world.
       As Gorton notes, the 2007-8 crisis was not one centered on commercial banks, but rather on dealer banks -- part of an unregulated shadow banking system. That's one of the most fascinating (and terrifying) parts of the crisis: as Gorton notes, its beginnings and foundations went essentially entirely unnoticed:

The crisis was not observed and not understood. Regulators, academics, and the media did not understand that there was a crisis. In fact, there had been a bank run, but it was a run on repo, which involved banks that were not regulated commercial banks. So the run was not observed. There needed to be large visible losses to galvanize the government into action. We had to wait until large firms were visibly in trouble.

       Trained to see good old-fashioned bank runs -- long lines of depositors, desperate to get at their money -- as the only true indicator of a crisis, Gorton argues everyone completely missed the boat with the very different sort of bank run that actually set everything in motion. Hence also missed was any opportunity of acting to prevent the crisis snowballing (as it then did).
       It's an interesting way of looking at the financial crisis, at its most fundamental. Gorton's conclusion -- the necessity of trying to implement policies that would again allow for 'quiet' -- is self-evident, but the book also serves as a useful reminder of what the focus of of policy-change should be (so, for example, obviously the focus should not be primarily on commercial bank activity, but rather elsewhere).
       The debt-trust focus (his summing up that crises are caused when market participants mistrust the value of bank debt) can be a slightly jarring perspective, especially since Gorton's focus is so very much on the absolute fundamentals. Thus, for example, he offers little insight and only the most fleeting mention of his own experience as a consultant to AIG Financial Products (i.e. in the very murkiest depths of that shadow-banking world ...), where he worked 1996 to 2008. Gorton's concern in this book is with the historic record and patterns and what lessons can be learnt from these; he does address some specific events from this crisis -- the decision to allow Lehman Brothers to fail, for example -- but there's relatively little discussion of much of what went wrong in 2007-8 and it's an odd sort of silence. (Interestingly, he does rather easily dismiss the subprime mortgage shock as the sole or even most significant explanation of the crisis, noting that: "Even if every single one of these mortgages defaulted with no recovery at all, it would not by itself explain the magnitude of the crisis" -- a rare example of what is surely overreach (as universal default on $1.7 trillion worth of mortgages surely would have been seen as so catastrophic on all levels that it would have triggered a considerably more devastating crisis).)
       Misunderstanding Financial Crises is a fascinating and valuable historical-theoretical study of financial crises. A big-picture book that doesn't examine much of the minutiae of the recent crisis too closely, it nevertheless offers a very good overview and certainly should help prod readers (and, one hopes, especially economists and policy-makers) to reexamine their thinking about the American financial system, and both the policy-changes that might be implemented and the areas of concern that must be watched over more closely in the future.
       A very good and accessible work.

- M.A.Orthofer, 24 October 2012

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Links:

Misunderstanding Financial Crises:

Oxford University Press publicity page

Reviews:

Gary B. Gorton:

Faculty page

Other books of interest under review:

See Index of books dealing with Business and Economics

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About the Author:

Gary B. Gorton teaches at the Yale School of Management.

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