What Really Happened

This is from David Warsh (note that, despite Dodd-Frank and other regulatory measures instituted since the financial crises,we are still susceptible to the shadow bank run problems described below):

What Really Happened - Economic Principals: ...the best economics book on the fall calendar ... (to be published next month) is a slender account about the circumstances that led to that near meltdown in September 2008, and an explanation of why they were not apparent until the last moment. Misunderstanding Financial Crises: Why We Don’t See Them Coming (Oxford University Press), by Gary Gorton, of Yale University’s School of Management ... can be viewed as an answer to the question famously posed to their advisers, in slightly different ways, by both George W. Bush and Queen Elizabeth: why was there no warning of a calamity that was warded off only at such great expense? The answer is that, lulled by nearly 75 years without one, economists had become convinced that banking panics had become a thing of the past. The book is probably better understood as the successor to Charles P. Kindleberger’s 1977 classic, since updated many times, Manias, Panics, and Crashes: A History of Financial Crises. This time, I think, the message won’t be brushed aside.

Not that building the near-certainty of periodic crises back into economics’ analytic framework will be easy. Gorton is an economic historian by training, and the economists with whom he collaborates mostly have monetary, financial or organizational backgrounds. This means they are up against macroeconomics, one of the most powerful guilds in ... virtually all of macro, from Edward Prescott on the right to Olivier Blanchard on the left, in the form of models of that describe economies in terms of dynamic stochastic general equilibrium (DSGE). More on that in a moment.

But Gorton, 61, possesses several advantages that Kindleberger (1910-2003) did not. He is an expert on banking, for one thing. (Kindleberger specialized in the international monetary system.) He’s mathematically adroit, for another, a quant. Most significantly, he is an insider, the economist whose models and product concepts were at the heart of insurance giant AIG’s Financial Products unit, whose undoing amid a stampede of competing claims was one of the central events of the crisis. As such, he had a front row seat.

Gorton’s case is ostensibly simple. Where there are banking systems, he says, there will be periodic runs on them, episodes in which everyone tries to turn his claim into cash at the same time. He sets out the pattern this way:

• Crises have happened throughout the history of market economies.

• They are about demands for cash in exchange for bank debt — debt which takes many different forms, not just retail deposits.

• The demands for cash are on such a scale – often the whole banking system is run on – that it is not possible to meet those demands, because the assets of the banking system cannot be sold en masse without their prices plummeting.

• Crises are sudden, unpredictable events, although the level of fragility may be observable.

• Crises, when they occur, may be contained, panics halted, but only at enormous cost.

• Preventing depression means saving the banks and bankers. As Treasury Secretary Timothy Geithner put it: “what feels just and fair is the opposite of what’s required for a just and fair outcome.”

The problem is that, starting in the 1970s, many economists convinced themselves that bank runs were something they no longer had to worry about, or even think about. They thought because the measures implemented during the Great Depression – deposit insurance, careful segregation of banks by line of business, and close supervision – had ushered in what Gorton calls “the quiet period.” Between 1934 and 2007 there were no financial crises in the United States. (Expensive as it was, the savings and loan debacle of the late 1980s and early ’90s, doesn’t meet the definition of a crisis. Some 750 of around 3,200 institutions failed, in slow motion, over a period of several years, but there was no run on any of them, because depositors expected that the government would make them whole.)

It was in these years that new models began taking over macroeconomics. These new models are said to be dynamic, because in them things change over time; stochastic, because the system is seen to respond to periodic shocks, factors whose origins economists don’t try to explain as part of their system, at least not yet; and general equilibrium, because everything in them is interdependent: a change in one thing causes changes in everything else. Best of all, such models are set to rest on supposedly secure microfoundations, meaning the unit of analysis is the individual or firm. One trouble was that no one had succeeded in building banking or transactions technology into such a model (though some economists had begun to try). Another was that the behavioral aspects of those microfoundations were anything but secure.

It turns out the villain in the DSGE approach is the S term, for stochastic processes, meaning a view of the economy as probabilistic system ... as opposed to a deterministic one... It is ... when economists begin to speak of shocks that matters become hazy. Shocks of various sorts have been familiar to economists ever since the 1930s, when the Ukrainian statistician Eugen Slutsky introduced the idea of sudden and unexpected concatenations of random events as perhaps a better way of thinking about the sources of business cycles than the prevailing view of too-good-a-time-at-the punch-bowl as the underlying mechanism.

But it was only after 1983, when Edward Prescott and Finn Kydland introduced a stylized model with which shocks of various sorts might be employed to explain business fluctuations, that the stochastic approach took over macroeconomics. The pair subsequently won a Nobel Prize, for this and other work. (All this is explained with a reasonable degree of clarity in an article the two wrote for the Federal Reserve Bank of Minneapolis in 1990, Business Cycles: Real Facts and a Monetary Myth). Where there had been only supply shocks and demand shocks before, now there were various real shocks, unexpected and unpredictable changes in technologies, say, or preferences for work and leisure, that might explain different economic outcomes that were observed. Before long, there were even “rare economic disaster” shocks that could explain the equity premium and other perennial mysteries.

That the world economy received a “shock” when US government policy reversed itself in September 2008 and permitted Lehman Brothers to fail: what kind of an explanation is that? Meanwhile, the shadow banking industry, a vast collection of financial intermediaries that included money market funds, investment banks, insurance companies and hedge funds, had grown to cycle and recycle (at some sort of rate of interest) the enormous sums of money that accrued as the world globalized. Finally, there was uncertainty, doubt, fear, and then panic. These institutions began running on each other. No depositors standing on sidewalks – only traders staring dumbfounded at comport screens.

Only a theory beats another theory, of course. And the theory of financial crises has a long, long way to go before it is expressed in carefully-reasoned models and mapped into the rest of what we think we know about the behavior of the world economy. Gorton’s book is full of intriguing insights, including a critique of President’s Obama response to the crisis, and glimpses of a pair of reforms that might have put the banking system back on its feet much more quickly had they been widely briefed and better understood: federally charter a new kind of narrowly-funded bank required to purchase any and all securitized assets; and regulate repo (the interest-bearing repurchase agreements through which financial giants created the shadow banking system), to the extent that there would be limits on how much non-banks could issue (a proposal recently defeated at the Securities and Exchange Commission after massive lobbying by the money-market funds).

There is going to be a long slow reception to Misunderstanding Financial Crises. Let’s see how it rolls out. I’ll return to the topic frequently in the coming months.