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.

An Inside View of the Mortgage Crisis

Important op-ed piece in today's WSJ by economist Charles Calomiris. I agree that Wall Street was at fault a lot in bringing about the financial crisis, but so was the government, especially through Freddie Mac and Fannie Mae. Calomiris helps doucment this.

Assorted Links

Several interesting papers and articles are available.

Paper by Jeremy Stein on securitization and the financial crisis.

Bernanke's testimony before the financial crisis committee.

Interview with William R. Allen who taught at UCLA for many years about the "glory " years of UCLA. University Economics, a principles text co-authored by Allen and Armen Alchian remains the best I have ever seen, although perceived by many as too difficult for most undergraduate students. I was a for Allen at one time, along with many other grad students there.

A Trio of Books that Help Explain the Recent Crisis

I recently posted about an excellent book on the financial crisis--Gary Gorton's SLAPPED BY THE INVISIBLE HAND. I now have two additional books to recommend. The first is by Carmen M. Reinhart & Kenneth S. Rogoff, THIS TIME IS DIFFERENT: EIGHT CENTURIES OF FINANCIAL FOLLY, and hte second is by Raghuram G. Rajan, FAULT LINES: HOW HIDDEN FRACTURES STILL THREATEN THE WORLD ECONOMY. One can get a good understanding of the causes of the crisis by reading these three books.

Reinhart & Rogoff look at eight centuries of data concerning financial crises. The information is sobering on at least two accounts--the frequency of the crises and the severity of the recession following a banking crisis. They also not that crises often follow a period when the belief at the time is that "this time is different" and complacency or hubris leads to problems. It is interesting to note that for many of the crises, a run-up of housing prices preceeded the collapse.

Gorton shows how much what happened can be described as a bank run in the shadow banking sector. Since I wrote on it previously, I won't add more here. Rajan's book tries to be the most comprehensive regarding the recent crisis. He pins the blame on the places I have suggested in the past--policymakers, the financial firms, the global saving glut, and poor regulation. He also discusses the problems caused by policymakers responding to a downturn given that the safety net in American society is less secure than in Europe. He notes a key pointsthat I think has not received adequate attention. Low interest rates have two negative effects--it reduces incomes of savers and it encourages people who want more return to take on more risk by increased leverage.

I highly recommend all three books for a greater understanding of the crisis. Hopefully, a better understanding can aid in determing how best to encourage a sustainable recovery.

Good Book on the Finanical Crisis

I finished reading SLAPPED BY THE INVISIBLE HAND: THE PANIC OF 2007 by Gary Gorton. It is the best book I have read on the crisis. The only drawback to the book is that it is mostly a collection of previously written articles. Most such books lack some continuity. It is less true for this book though since two long chapters were written after the crisis began.

Gorton's book isn't the complete story, but it covers a key component to the crisis--how did problems in subprime markets lead to the collapse of the banking system? He shows how it happened and shows that it was basically a bank run. The difference between the recent situation and traditional bank runs is that it took place out of sight in the "shadow banking system." That is, the run was by firms on other firms and didn't involve tradional depositors.

Unfortunaely, Gorton's book is unlikely to get the wider readership that it deserves since it is more technical and doesn't focus on the conflicts among different business and government leaders or see evil around every corner. I found the book very enlightening and highly recommend it.

Can We Learn from the Financial Crisis Inquiry Commission?

Good article in the New York Times today about the work of the Financial Crisis Inquiry Commission. Joe Nocera describes the commission as seriously seeking answers to what went wrong--unlike the Congressional hearings. It is six months still before their report will be due. It should provide interesting reading once it is available.

Taylor on the Financial Overhaul Bill

Good op-ed piece in the WSJ today. Stanford economist John Taylor, known for the Taylor Rule that tracked well the Fed's interest rate setting until the mid-2000s, argues the financial overhaul bill will be ineffective in preventing another crisis because it doesn't address the causes of the crisis.

There may be good reasons for some of the changes in the bill. One needs to examine the details more closely, as well as the actual regulations developed after the bill is passed, to have an idea whether this is so. Even then, we may need experience with the regulations to have a better idea about the efficacy of the regulations. But we have better ideas today about the causes of the crisis and clearly the bill does not address them.

Financial Regulation Bill

The financial regulation bill has a finalized form from the reconciliation conference. (See WSJ article here.) It will take some time to read through the bill and evaluate it. At this point, I just want to note that the task force President Obama put together to determine the causes of the financial and economic crisis has not finished its work or put together a report. Yet, we get a bill to prevent anything like this from happening again (according to Sen. Dodd). Just what is the point of the task force then?

Charles Calomiris offers a spiritual response to the financial crisis

Thanks to my former colleague, Doug McMillin, for the reference to a talk Charles Calomiris gave in March of last year. (The paper can be found here.) He identifies four causal factors to the crisis--factors that have been mentioned in this blog before. He also discusses some ways out. Finally, he looks at examples of people making decisions is crises--including biblical figures Ruth and Job, and historical figures such as Alexander Hamilton, JP Morgan, and Andrew Mellon. All in all, an interesting paper.

Government as Co-Conspirator

In my previous post I cited a WSJ op-ed piece, in which the author argued that the government has been a co-conspirator with many on Wall Street in running up debt that led to the financial and economic crises. I think the article still focuses too much on Wall Street and not enough on the government. It does note that the recent actions of the government, both the Fed and the Treasury, are similar to actions taken several times over the last thirty years. The most surprised and disappointed man in America had to be Dick Fuld, CEO of Lehman Brothers, when the government didn't resuce them the way it did so many others in the past. Given what happened afterwards, it is very doubtful the government will ever let any large financial institution go under again. So, the moral hazard issues continue. The short-term approach followed by the Fed and Treasury also continues.

Government as Co-Conspirator in Financial Meltdown

Interesting op-ed piece in today's WSJ. Am busy so no time to comment today but will do so soon.

Odds and Ends

A couple of items to look at if the reader is interested. Sunday's NY Times business section had a number of good articles and columns about the year anniversary of the collapse of Lehman Brothers. Definately is worth a look.
On another topic, a blog that relates economics and theology that I find very good is Kruse Kronicle. He is providing a series of posts on key economic issues. The first dealt with scarcity, a concept accepted by economists but there are theologians who dispute that scarcity if a worthwhile starting point.

We Are Moving into a Time of Reregulation

One of the reasons given for the current financial crisis is deregulation, which permitted greedy Wall-Street-types to earn huge incomes by taking excessive risk. We can expect to see an increase in regulation in the near future. Treasury Secretary Geithner is calling for increased regulation in the financial sector.

While I will not argue that some changes in regulation may be needed, I fear that the changes that will be implemented will not lead to a better financial system. Why? For several reasons. First, when the consensus of policymakers is that we are in a crisis, the likelihood of passage of poorly conceived and poorly thought out laws and regulations is high. At least some of the deregulation movement in the past developed because deficiencies in the regulations that existed at the time had become apparent. Second, regulation tends to be reactive--reacting to the perceived shortcomings of the situation without knowing the effects of the regulations when the economic environment is different. This reflects the general concern economists have for the unintended consequences of government actions. Third, between government officials and the press, one could think that regulators will be wise, impartial, selfless public officials, and they can oversee the selfish, risky actions of the people working in finance. But all are human beings. All lack omniscence; all lack perfect foresight.

Economists who work in the economics of regulation long ago gave up the idea that regulation was done in the public interest. Instead, it is recognized that regulators are impacted by interest groups. Further, interest groups include, but are not limited to, those in the industry that is regulated. As we examine the current situation and the politicians who are key figures of key committees in the House and the Senate, can we not expect that those interest groups that Barney Frank and Christopher Dodd pay attention to will have more influence in the outcome of legislation than other groups? (I use the two men only as an example and am not accusing them of nefarious behavior. This is how our system of representative government works.)