Eugene Fama, whom many regard as the father of modern finance, was asked in a May 2012 interview what he thought was the cause of the 2007–08 financial crisis. Fama replied,
"I think the global crisis was first a problem of political pressure to encourage the financing of subprime mortgages. Then, a huge recession came along and the house of cards came tumbling down."1
This not-unconventional assessment is precisely what Yale economist Gary B. Gorton seeks to refute in Misunderstanding Financial Crises. He argues that the latest crisis resulted from the same phenomenon that has triggered most financial crises—namely, a bank run.
Economists failed to foresee the bank run and did not recognize it when it happened, according to Gorton, because they were using obsolete definitions of “bank” and “money.” In today’s economy, he writes, not all “banks” are depository institutions that hold bank charters. The category also includes investment banks and money market funds. Money, similarly, comprises not only currency and demand deposits but also repurchase agreements (repos) and asset-backed commercial paper. Loss of confidence in the asset-backed instruments constituted a run on this shadow banking system, defined by Gorton as “a new depository banking system that arose to meet the needs of large depositors.” The consequences, in Gorton’s view, were exactly analogous to those of the old-fashioned bank run, in which small depositors frantically attempted to withdraw their savings.
Economists were caught off guard by the crisis for a second reason, in Gorton’s judgment. He shows that most of them populated their models exclusively with data drawn from the years following World War II and preceding 2007, during which there were no systemic financial crises in the United States. The economists ignored earlier periods, when crises occurred fairly regularly, because of the lesser availability of data for those years and a belief that changes in the economy’s structure had rendered the earlier evidence irrelevant. Models constructed in such a manner were bound not to predict a financial crisis, especially given economists’ belief that crises were a thing of the past. The more recent change that the experts missed, says Gorton, was reduced insulation of banks from competitive pressure, leading to greatly increased risk taking on their part.
Gorton also challenges conventional wisdom regarding the appropriate policy responses to financial crises. Many commentators have denounced governments and central banks for bailing out banks in 2008 to prevent a global meltdown. These rescues, say the critics, saved the undeserving bankers in the process of saving the banks. Much worse, they created moral hazard (i.e., they encouraged the largest banks to take outsized risks in the future) by assuring the banks that regulators would deem them too big to fail.
In contrast, Gorton, adopting a descriptive rather than a normative mode, shows that from the early 19th century onward, the usual government response to all banks simultaneously failing to meet depositors’ demands for cash was to let them off the hook. The only alternative to allowing banks temporarily to renege on their commitments was to liquidate the entire banking system.
A key point is that the legally dubious but pragmatic policy that constituted the norm did not apply to isolated bank failures. It was used only during general bank panics. Accordingly, Gorton argues, a properly conceived bailout creates no moral hazard. A bank that overextends itself cannot guarantee that it will face insolvency at the same time as all other banks and, therefore, cannot count on receiving a bailout.
Gorton plunges deeper into controversy by rejecting the prevailing view that boosting capital requirements is essential to preventing future financial crises.2 Once again lending valuable historical perspective to the question, he argues that the true source of bank failures is a lack of cash and an inability to convert other assets to cash. “There is almost no evidence that links capital to bank failures,” he writes. “The commercial banks that failed in the recent crisis held, on average, more capital than Basel III required.” (Gorton acknowledges that larger capital cushions reduce the costs that idiosyncratic bank failures impose on deposit insurance schemes.)
Certain elements of Gorton’s theses have been questioned by analysts who place more blame than he does on banking practices prior to the financial crisis. For example, at the 20th Annual Hyman P. Minsky Conference in 2011, Gorton argued that the subprime shock could not account for the financial crisis because losses on subprime mortgages were not very large. He cited research that calculated realized losses during the crisis of only 17 bps on AAA subprime bonds issued between 2004 and 2007.3 One conference attendee objected that this figure understated the damage by focusing solely on realized losses. “Someone in the audience did try to call [Gorton] on ‘realized’. Gorton mocked the gentleman by simply repeating ‘realized’ in a tone intended to suggest that the interruption was ridiculous, and then moved on.” 4 Notwithstanding Gorton’s meticulous documentation, featuring 25 pages of bibliographic notes plus extensive endnotes and references, it is appropriate for other researchers to scrutinize the evidence underlying his bold assertions.
On a less momentous level, Misunderstanding Financial Crises contains several surprising errors. Gorton misspells the names of Paul Volcker, Warren Buffett, and the French economist and statesman Michel Chevalier. He also attributes to the baseball player Yogi Berra this quotation: “In theory there is no difference between theory and practice. In practice there is.” An easy internet search quickly discloses that credit actually belongs to the late computer scientist Jan L.A. van de Snepscheut.
Unquestionably, however, Misunderstanding Financial Crises enriches the debate concerning the events of 2007–2008. The book underscores the dangers of moralizing and temporizing when, in U.S. Treasury secretary Timothy Geithner’s words, “what feels just and fair is the opposite of what’s required for a just and fair outcome.” 5
Constructively, as well, Gorton protests the contemporary tendency of mathematics to crowd history out of the study of economics. He quotes Yale economic historian William N. Parker on the limitations of colleagues who lack historical background:
Such an economist becomes a shallower, narrower analyst with feeble capabilities for adapting the theory and statistics he has mastered to new and strange social environments. All problems strike such a one as new.
Crystallizing a theme that runs throughout the book, Gorton laments the fact that economics PhD programs have ceased to require at least one term of economic history. He wishes it were more obvious to other observers “that each crisis is not due to coincidental bad events or unique institutional features.” Gorton has a point. It seems undeniable that regulators would benefit from knowing how their predecessors coped with problems that have lately reappeared in new guises.