Gary Gorton, an academic economist at the Yale School of Management, has an unusually simple explanation of banking crises: they’re all about panic over the value of debt. In his latest book, Misunderstanding Financial Crises, he explains that the 2007-08 financial crisis was no different.
In order to explain to the reader what caused the Great Recession, Gorton reviews the history of money and banking in the U.S., from the Free Banking Era to today. Although finance looks drastically different today than it did in 1863, Gorton argues that there are key continuities, especially in the ways regulators misread the same problems in capital markets.
RealClearPolicy emailed Gorton to ask him about his book and financial crises. Below is a lightly edited transcript of our conversation:
RealClearPolicy: There are many competing and confusing explanations for the financial crisis of 2007-08. Yet you argue that the root problem was no different from what caused financial crises as far back as the period after the Civil War. Could you explain that in terms the average person would be able to understand?
Gary Gorton: Think of the bank run in the movie “It’s a Wonderful Life,” often shown at this time of year. In the movie the people of Bedford Falls run on the Bailey Building and Loan Association, demanding the return of the cash they have on deposit in their checking accounts. A bank run is when this happens at all banks at the same time. As President Roosevelt explained in his first fireside radio chat on the banking crisis during the Great Depression, when everyone wants their cash back at the same time, it is not possible for the banks to come up with the cash. They have lent it out and they cannot get it back. The entire banking system then is in trouble unless the government does something. You can hear the address:
What happened in 2007-2008 was also a bank run, only this time it was not people wanting money out of their bank accounts, but institutional investors wanting their money back from investment banks. There are no insured checking accounts for large depositors like firms and institutional investors. They rely on an arrangement that is essentially the same as a checking account. They deposit money overnight at interest. If they do not want it the next day, they leave it there. But, if they get nervous then they withdraw.
The public did not see the bank run in 2007-2008, unlike previous bank runs in U.S. histories which were seen by everyone. Without seeing the bank run, people had no clear picture of what happened. A clear narrative of the crisis was never forthcoming from the authorities, unlike President Roosevelt’s address. And so, superficial narratives were accepted and informed policy. This is unfortunate, but is consistent with U.S. history.
What did policymakers do right during in the crisis-free years between 1934 and 2007, which you refer to as the “Quiet Period”? Would it be possible to recreate that regulatory scheme? Did Dodd-Frank succeed in doing so?
During the long period between 1934 and 2007 the U.S. did not experience a systemic event in which the entire financial system was on the verge of collapse. In large part this was because deposit insurance was passed in 1934. Since then, the financial system has evolved, changed. Change is an essential feature of market economies; there is always constant change. The new system of deposit-like accounts for institutional investors and firms grew to become very large, just as 150 years ago checking grew to become very large. It took 80 or so years for the banking panics associated with checks to be ended with government insurance.
It would be possible to design a regulatory system that could create confidence in the new financial system and protect it from runs. Dodd-Frank does not do this. Dodd-Frank does many good things, but it does not address the core issue of bank runs. This does not mean that insurance is required. It does mean that a very precise issue must be addressed. It does not appear that this will happen.
It sounds like you’re predicting another ’07-08-style financial crisis in the not-too-distant future. Wouldn’t Dodd-Frank prevent such an event from being as bad as it was last time around? After all, the law increases regulations for too-big-to-fail firms, and provides for them to be resolved without creating a scenario like the Lehman Brothers one, with resolution authority and living wills that require banks to spell out how they pay off creditors in case of insolvency.
I don’t know about the timing of the next financial crisis, but since we have not solved the problem there will be one at some point. Between the Civil War and World War II the U.S. had crises in 1873, 1884, 1890, 1893 1907, 1914, and the Great Depression, so we may be back to that pattern.
The idea that we can “resolve” banks with living wills does not recognize the reality of these crises. During a crisis the whole financial system is at risk. In Bernanke’s testimony to the Financial Crisis Inquiry Commission he said that, of the 13 largest financial firms in the U.S., 12 were about to go under. It would not make any sense to “resolve” these firms. As a practical matter, a crisis happens very fast and happens under unexpected circumstances. In such a setting there cannot be orderly procedures. The problem is not banks that are “too big.” Financial crises happen in banking systems without large banks.
It would be better to avoid financial crises rather than try to have systems in place to “prevent such an event from being as bad as it was the last time around.”
The run on shadow banks began in 2007. Five years on, the economy hasn’t seen a real recovery. Is that what you would have expected when you wrote Slapped by the Invisible Hand? Didn’t pre-1934 banking runs feature a lot of strong, bounce-back recoveries after financial crises? In other words, does your argument explain why this recovery has been so weak?
The empirical evidence shows that it takes quite a while to recover after a financial crisis, about a decade—a “lost decade.” Bounce-backs do not usually occur after a financial crisis, but can occur after a recession without a crisis. This aftermath of this crisis is unfolding in the usual way.
We have learned to avoid Great Depressions, but we have not learned how to avoid the aftermath of financial crises. The banking system is in a weakened condition and millions of people are still at risk of foreclosure on their homes. No positive steps have been taken to rejuvenate the banking system or to help homeowners.
What would be a positive step to rejuvenate the banking system? And what could the administration or Congress do for housing that they haven’t already done or aren’t already doing?
Rejuvenation of the banking system means restoring confidence in securitization, which is the process by which banks sell loans. In the modern banking system banks sell loans because it is profitable to do so. It is not profitable to hold these loans on their balance sheets. Securitization must be brought under the regulatory umbrella so that the collateral backing the deposits of institutional investors is scrutinized by bank regulators. There are several ways to do this, but the details are not important until it is recognized that “shadow banking” is real banking. It is an integral part of the economy.
Nothing was done about mortgage relief. There is currently no discussion of mortgage relief, although many proposals have been put forward. Again, at this point, the issue is not what should be done, but rather the problem is the failure to recognize that something should be done.
Unfortunately, the attention of politicians has shifted away from issues to do with the aftermath of the crisis. That is the real problem. The crisis is not over.