Monday, November 19, 2012

Review of Gorton's Newest Book--Misunderstanding Financial Crises

I just read Gary Gorton's new book and it is excellent.  I have written on Gorton's earlier book, SLAPPED BY THE INVISIBLE HAND, and this new book, MISUNDERSTANDING FINANCIAL CRISES: WHEY WE DON'T SEE THEM COMING, is also invaluable in understanding the recent financial crisis.  Once again, Gorton focuses on the shadow banking system and how there was a bank run in August 2007 involving this system.  He also discusses many of the financial crises in the past in the U.S., and how we had them in the free banking era, the national banking era and after the Fed was created.  Gorton argues also that economists ignore history too much and this causes us to consider each crisis as unique when there are many similarities among the crises.

Gorton calls the era from the creation of the FDIC and deposit insurance for banks to the early part of the new century as The Quiet Period--a long time period in which we did not have a financial crisis involving the banking system as a whole.  The deposit insurance meant that depositors would not have to race to the bank to pull out their funds when concern over the liquidity of the banks existed because their funds were safe.  This ended the problem of bank runs as traditionally defined.  But financial innovations in response to inflatoin in the 70s as well as competition, changed the environment and the shadow banking system emerged that involved investment banks, other large financial insitutions, corporations and hedge funds.  It was this system that experienced the bank run in 2007.  At the end, Gorton provides some arguments for what can be done to prevent a similar run in  the shadow banking system in the future, noting that Dodd-Frank does not provide the solution.  He also makes clear the important distinction between the function of capital in the system when times are normal versus times of crisis.  Increased capital requirements do not solve the problem when the system is in crisis.

I recommend the book highly. It is less technical than his earlier book and seems more unified since the earlier book involved chapters that had been articles in journals.  I think that a real solution to the problems of periodic financial crises involving banking will not be solved without taking into consideration the arguments in this book.

There is also a recent article on the shadow banking system that can be found here.

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