Explaining the financial crisis

I rather said this over here.

Originally written for a conference of the Federal Reserve, Gary Gorton\’s \”The Panic of 2007\” garnered enormous attention and is considered by many to be the most convincing take on the recent economic meltdown. Now, in Slapped by the Invisible Hand , Gorton builds upon this seminal work, explaining how the securitized-banking system, the nexus of financial markets and instruments unknown to most people, stands at the heart of the financial crisis.
Gorton shows that the Panic of 2007 was not so different from the Panics of 1907 or of 1893, except that, in 2007, most people had never heard of the markets that were involved, didn\’t know how they worked, or what their purposes were. Terms like subprime mortgage, asset-backed commercial paper conduit, structured investment vehicle, credit derivative, securitization, or repo market were meaningless. In this superb volume, Gorton makes all of this crystal clear. He shows that the securitized banking system is, in fact, a real banking system, allowing institutional investors and firms to make enormous, short-term deposits. But as any banking system, it was vulnerable to a panic. Indeed the events starting in August 2007 can best be understood not as a retail panic involving individuals, but as a wholesale panic involving institutions, where large financial firms \”ran\” on other financial firms, making the system insolvent.
An authority on banking panics, Gorton is the ideal person to explain the financial calamity of 2007. Indeed, as the crisis unfolded, he was working inside an institution that played a central role in the collapse. Thus, this book presents the unparalleled and invaluable perspective of a top scholar who was also a key insider.

Banking systems without deposit insurance are, as we well know, likely to be subject to runs. The financial system had moved, over the decades, from a system largely running on retail deposits (with deposit insurance after the runs of the 30s…that\’s US stylee history of course) to one largely running on wholesale deposits (with no such insurance).

Thus when a problem arose we had a run.

As with any problem we should look at both proximate and ultimate causes. The bonuses, greed, tax, securitisation, repo, derivatives and all can be seen as proximate causes if you like. But the ultimate cause was simply a banking system without deposit insurance.

Which means that the solution to the problem is deposit insurance, not actions on bonuses, greed, tax, securitisation, repo or derivatives.

Which means that, uniquely so far in the history of the Administration, Obama has got one right. The solution is indeed a charge upon liabilities to create deposit insurance for the wholesale markets.

We should also distinguish between two further points.

The first is Dean Baker\’s. No, it wasn\’t the structure of the financial system (or bonuses, greed, tax, securitisation, repo or derivatives) which caused the recession. It was a housing bubble that then burst. $8 trillion of wealth evaporated in the US alone. That will, relative to the size of the US economy, always produce a recession.

Any financial system will be in trouble when something like that happens: the S&L problems of the late 70s, early 80s, when none of the more exotic instruments existed, when housing finance was largely in the hands of mutuals and credit unions shows that.

The second is that above. The transmission from the evaporation of wealth to the financial system falling over was the lack of deposit insurance on wholesale funds.

The solution is thus to address the two ultimate causes. The prevention of a housing bubble and the provision of deposit insurance.

Everything else, the bonuses, greed, tax, securitisation, repo or derivatives, is froth. and if we address the froth only then we\’ll not solve the underlying problem and thus leave ourselves open to it happening again.

10 comments on “Explaining the financial crisis

  1. well OK, but I very much doubt Gorton himself would describe securitisation, repos, derivatives etc. as mere froth, nor, I believe, would he limit the regulatory reforms to the two you identify as fundamental.

    Even accepting your diagnosis, it still makes perfect sense to think about how things like securitisation, repos, derivatives were used in harmful ways, and perhaps how the structure of bonuses added some fuel to the fire, and to consider making changes to all or any of these things.

    Tim adds: I do allude to that….but concentrating upon, as so many do, the froth means we’ll not solve the two basic problems.

  2. out of interest, does Gorton actually recommend deposit insurance? there are other ‘solutions’, such as discouraging reliance on short-term wholesale financing. See here: http://www.voxeu.org/index.php?q=node/4749

    I take your point about popular emphasis on froth as opposed to really trying to understand the fundamentals.

    You could argue that some of the ‘froth’ both explains why house prices rose so fast, and how banks managed to get themselves into a position where the bursting of the bubble would screw’em. Don’t forget, the wholesale “run” was caused by the knowledge that banks assets were crap, that’s the other side of Gorton’s coin. See for example here:


  3. “Which means that the solution to the problem is deposit insurance”

    It would probably avoid the problem of runs, but I think the unintended consequences and moral hazard could be so horrific as to outweigh the benefit.

    Provide insurance against loss and the rational approach becomes to seek out the biggest, riskiest return, because the risk of loss gets taken out of the investors’ thinking.

    In order for the insurance to be effective, it generally needs state backing too, so it also externalises the risk to the taxpayer.

    Having insurance on wholesale deposits would turn banks into risk removing investment vehicles. Rather than invest directly in a business, investors would have a greater tendency to invest through a bank, which would remove the risk of capital loss.

    Removing the fear of loss is a double edged sword. It reduces the risk of a run, but at the cost of encouraging investors to throw money at get rich quick schemes without worrying about their stablility.

    I can see, although I don’t agree with, the reasoning behind deposit protection for smaller depositors, as they have less time and fewer resources to study their options, but that certainly shouldn’t apply to larger investors.

  4. for once it is a pleasure to agree with Paul Lockett: deposit insurance, particularly if it is provided by the taxpayer, is a moral hazard issue.

  5. But surely the point is that if it’s provided by the tax payer there is no real “market price” for the premium that different insurers would charge for different deposit-takers.

    However, I think most people are missing the biggest trick of the lot, or perhaps too despondent about its prospects of success to bother with – the cause of this boom and so this bust is a money system that can be manipulated by politicians for political ends coupled with a banking system from which the underlying risk of having to guarantee the token they are trading in is externalised onto those states.

    A free money system, with a thriving free market in risk insurance seems the only answer to me. Without it, we will repeat this again and again.

  6. “Banking systems without deposit insurance are, as we well know, likely to be subject to runs. ”

    Only if banks are not allowed to diversify risk. The US policy of unitary banking – banks limited to 1 branch or a restricted to a small geographical area – was the main cause of runs.
    Deposit insurance was introduced in the US to protect small banks from competition from bigger banks – Senators were frightened of losing their political funding.

  7. Everybody is barking up the banking tree.How about preventing housing bubbles? Texas did n’t bubble having 2%>3% p.a. taxes on house prices.When Sir Peter Burt suggested a similar 1% tax on Scottish houses there was uproar and his report was thrown back at him.
    In the UK LVT is a better option because land value is such a huge proportion of house price inflation.

  8. To some extent I’m wth DBC Reed here. Banking is not the only culprit. Globalisation and free markets, enthusiastically promoted by governments, must take some of the blame.

    To prosper a national economy needs jobs, real jobs not public service jobs. Tax eaters as Cobden decribed them 200 years ago contribute little to the real economy.

    So if we export real jobs and replace them with sinecurs for tax eaters we have a problem. There are things to be said for protectionism.

  9. Ed Butt, it is not globalisation that caused the crisis. Rather, it is central banks – which would not be able to exist in a free market banking system – printing money that has fuelled much of the crisis. And “too big to fail” bailouts and the rest have encouraged recklessness by the banks themselves.

    There is nothing to be said for protectionism, at all. The idea that we “lose” “our” jobs to those evil foreigners for the sin of selling us cheaper goods and services is absurd, since as foreign nations earn the attendant revenues, they have to spend that money, and new sources of wealth spring up, and so on.

    The idea that free markets are “enthusiastically” promoted by governments is also a bit of myth. With a few exceptions, what governments have promoted is a sort of controlled capitalism, with many governmental rules in place.

    The idea that we have been living through some sort of 19th century laissez faire era will come as a surprise to anyone who has had to contend with the red tape and taxation of most governments in the West.

    As for LVT, I am sure Mr Reed would agree that in the case of Texas, that state has not avoided financial blowups in the past. In the 1980s, for example, that state, along with many others, was hammered by the Savings and Loan meltdown, in some ways an episode every bit as bad as the current one.

  10. It’s a strange juxtaposition to say “there are things to be said for protectionism” immediately after quoting Cobden, whose most prominent achievement was spearheading the abolition of the protectionist Corn Laws.

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