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.