Guess what? It wasn\’t the greedy bankers!

You describe in the book how the ability to witness a bank run in person can affect the psychology behind the public’s (and the government’s) reaction to it. How is it different now that bank runs take place electronically and via phone rather than on the streets?

In a pre-deposit insurance bank run, people would line up at their banks to withdraw their cash. Everyone would see the lines and understand that this was a crisis. But still it took over a century in the U.S. before this problem was solved with deposit insurance, which by the way was a populist mandate. Everyone—except the American people—opposed deposit insurance because it was supposed to create “moral hazard.”

Things are worse now because the bank run of the recent crisis was not observed by outsiders. Most people did not observe it and have no idea what happened. This compounds the problem because it leads to effects being mistaken for causes. The run resulted in about $1.2 trillion being withdrawn from dealer banks, which then had to sell assets causing bond prices to plummet. Plunging bond prices caused losses for many firms, many of which failed. The failures were observed, but not the cause. So, the popular narratives focused on bad greedy bankers and other superficial explanations.

Okay, but you can’t be saying that “bad greedy bankers” played *no* role in the crisis, right? That issues like mortgage fraud, lax underwriting, misrepresentations by mortgage lenders to the GSEs, things like the Magnetar and Abacus cases and other items that we’re still picking through should be minimised?

If greedy bankers cause crises, we would have a crisis every week. The Quiet Period from 1934 (when deposit insurance was adopted in the US) until 2007, during which there were no systemic crises, is not explained as being due to non-greedy bankers. What, then, caused bankers to suddenly become greedy? In every crisis in history, it happens that fraud is uncovered. Partly this is due to the fact that everyone asks for their money, and sometimes it cannot be produced (as with Madoff). Other times it is the heightened scrutiny of the financial system that reveals these problems.

I am not saying that these problems are unimportant. But I am saying that an explanation of the recurrence of systemic financial crises throughout the history of market economies cannot be explained by greed or fraud, etc. These are not explanations of crises and they are not the central problem. We are talking about systemic crises: that is crises in which the entire financial system is at risk. In Bernanke’s testimony before the U.S. Financial Crisis Inquiry Commission, he said that 12 of the 13 largest financial firms in the US were about to fail. How exactly does greed cause that, but it did not during the Quiet Period?

But you also write, for instance, that historically many bank runs have started after credit-driven land price and real estate booms. It seems like mandating more prudential lending standards would help — if not prevent future bank runs, then make them less frequent or less severe.

I don’t think that will help. It is an inherent feature of private economies that they cannot create riskless debt. What is the proposed lending standard, that banks are only allowed to make riskless loans? The fact is that the economy needs and wants private bank money—short-term bank debt. Such debt cannot be completely riskless.

Gary Gorton is The Man.

Bank runs, and thus financial crises, are inevitable in a system of fractional reserve banking. And we do indeed have to have FRB because we need to have maturity transformation.

So we\’re stuck with the idea that we will have financial crises. And it\’s got sod all to do with neoliberalism, the greediness of bankers or any of the other fashionable nostrums.

22 thoughts on “Guess what? It wasn\’t the greedy bankers!”

  1. Strongly approve of Tim W’s point here. FRB and deposit insurance are both essential to a functioning economy; only communists and “abolish the cops and let guns sort it out” libertoonians would disagree.

    (Tim N’s suggestion that the government mandated lending to people who wouldn’t pay it back is silly, however: CRA loans performed far better than non-CRA loans. There was just too much money sloshing about for more-or-less free at the time, and as a result of the way the banking system works it got lent to people who couldn’t pay it back whether they were black, white or purple).

  2. Worth pointing out before Paul does that Gary was the guy who did the modelling for AIG FP and their sale of insurance protection on subprime CDOs. He was right that the risk of these securities was very very low but failed to take into account the massive panic which caused these things to fall to ridiculously cheap levels in late 2008.

  3. The key point is being missed though, which is that banks which fail must be allowed to fail, but cannot in the current corrupt government-backed system be allowed to fail, so the government has to give them taxpayers money, and the bankers know that, so even when they are knowingly doing unspeakable things with their depositors’ money, they carry on doing it.

    This is why you have to be a special kind of cunt to be a banker. It’s not so much about greed– we are all greedy- it’s about being sufficiently psychopathic that you don’t care about the consequences of your greed.

    One essential part of the answer is the need to separate the separate the money supply from the bankers, which, if you’re going to have a national currency, means having the government print the money instead of the banks printing it. The result being that if and when the banks fail, they don’t take the money with them. Just like in the old days with gold; if a bank lost all its gold, the gold still existed in other parts of the economy.

    It is baffling why anyone would continue to justify a system in which a government- which has the power to do anything, including creating money- instead deliberately pays private banks for the thrill of borrowing it into existence. It is hard to think of anything more insane.

    It might be something to do with the frequency with which politicians get offered jobs as “consultants” to said banks after their careers end in failure. Who can say?

    ” In 2011/12, the debt interest payments on UK debt are anticipated to be £48.6 bn (3% of GDP). ”

    That’s nearly 50 billion pounds worth of production shoved down the toilet this year, to keep the bankers in comfort. Fucking disgusting.

  4. Actually, I was thinking about this the other day, and I thought up a fun solution which would be morally acceptable in these days that the old tumbrels and guillotines are considered too barbaric. It goes like this-

    You have a system whereby, when any financial institution (or indeed clapped out business) goes to the government for a bailout, they can have one. But. The board have to appoint somebody to roll a dice and, if they roll a 6, all members of the board and senior officers, etc, are removed, stripped of all their personal wealth and assets, and thereafter put on a special tax code for the rest of their life which is 100% for any income above 75% of the national median wage (index linked of course). They will also be entitled to any appropriate benefits, and to join the waiting list for a council flat, and so on.

    That might help fix the moral hazard problem.

  5. Tim N’s suggestion that the government mandated lending to people who wouldn’t pay it back is silly

    Was there or was there not legislation introduced in the US which attempted to prevent mortgage lenders from discriminating against those deemed to be of low incomes and therefore less able to repay?

  6. Austrian Business Cycle theory also helps here; when the State holds the interest rate deliberately low to “stimulate” the economy, an essential signal to lenders is lost, so they keep lending when rising free market interest rates would have warned them the money was running out.

    The sub-prime borrowers wouldn’t have been able to afford free market mortgages. So the government mandate was part of the problem, but so was too much easy money sloshing around the pockets of excitable bankers- who generally do not understand economics, and that latter point is worth briefly exploring.

    It is important to note that most major economic players- bankers, politicians, etc- do not understand or care to understand economics. They understand the system they work with. Analagously (or metaphorically) like a man who runs a nuclear power station, who knows nothing about nuclear physics but has been trained to know that if that guage there starts rising, you hit that switch there and turn that knob to the left. Unfortunately, the banks are running with half the guages not registering correctly because the central bank is jamming them hard left, hard right, hard left, hard right, while it tries to guess what the reactor ought to be doing, instead of leaving them connected to the reactor itself. And since our engineers don’t understand nuclear physics, they don’t understand what is wrong with this.

  7. Was there or was there not legislation introduced in the US which attempted to prevent mortgage lenders from discriminating against those deemed to be of low incomes and therefore less able to repay?

    Were loans carried out on this basis more or less likely to default than loans that were granted not on this basis? (answer: less)

  8. That’s nearly 50 billion pounds worth of production shoved down the toilet this year, to keep the bankers in comfort. Fucking disgusting.

    No, that implies a level of management-reaping-benefits that hasn’t yet been achieved in the UK (although some Yank companies have come close). Let’s assume that Sir Useless Crook gets a million, his boss Sir Inept Chairman gets half a million, and the next 50 most important people at the company get half a million each – that’s gbp26m.

    So we’re actually seeing 999/1000 of the shenanigans being redistributed, one way or another – whether that’s into a railway or some dude who wants to borrow a few grand doesn’t really matter.

  9. Tim

    The way you’ve quoted the FT makes reading very difficult. It isn’t apparent that this a a dialogue with two different people contributing. At least make the questions bold

  10. @IanB

    Bankers are no more greedy than doctors or lawyers or you. Sure they get paid a lot, and in most cases too much, but that is because of the system. Bankers sit at the nexus of a system in which the daily flows are enormous. Taking a fee of 0.01-0.1% out of these transactions can add up to a lot of money. And one banker who has an edge can make a difference which can be worth millions.

    Also the ones who get paid a lot are on the investment banking side and have nothing to do with money creation. Lehman did not have a cent of depositor money. Nor did Goldman Sachs.

    What’s funny is then that you blame bankers for the interest payments on government debt. Maybe the government should borrow less ? Or maybe you want the government to print money? That money is not all being paid to banks but also to insurance funds and pension funds.

    Also, if you think there is no moral hazard on banking then ask all of those shareholders who held bank stocks through 2008 if they agree.

  11. Who cares about deposit insurance, if other banks are unwilling to lend to other banks, you’re still in the shitter. And the talk about government creating ‘riskless assets’ is just BS. There is no such thing as a riskless asset; risk is part of living, deal with it.

  12. Financial panics are just that, panics. They are the same phenomenon as a cattle stampede – and just as dangerous. At the individual level, fear is a rational response, but in aggregate it can have appalling effects, such as bringing down the financial system.

    Gorton’s idea seems to be that if you stop people fearing they will lose their money, they won’t stampede. I agree up to a point, but I also agree with Mario that there is no such thing as a riskless asset. Neither government debt nor cash are riskless. If people stop trusting them, they stampede, creating a run not on banks but on government. The result is a sovereign debt crisis and/or hyperinflation.

    I don’t have a solution to this. I wish I did.

  13. john b-
    “Were loans carried out on this basis more or less likely to default than loans that were granted not on this basis? (answer: less)”

    Do you have a link or ref. that supports this? Would be of interest to me.

  14. Frances-

    Financial panics are just that, panics. They are the same phenomenon as a cattle stampede – and just as dangerous. At the individual level, fear is a rational response, but in aggregate it can have appalling effects, such as bringing down the financial system.

    This seems to be buying into a similar paradigm to the quote in the article, as if financial collapses are some kind of system error and the problem is preventing these system errors. It’s part of this problem of modern mathematical economics, which tries to see the economy as simply a mathematical system divorced from what the actual economy is about; it’s almost Platonic in its essentialism.

    We must remember that every “crash” in history has been a rational response. Indeed, the “crash” phase represents a return to rationality after a previous period of irrational exuberance which is almost invariably based on the same fallacy every time; that everyone can get rich simultaneously because some commodity or financial instrument will keep accruing market value forever (tulips, land, railway shares, “stocks and shares”, tech stocks, mortgage-based financial instruments etc).

    It is the point when the players in the market realise that this thing is overvalued, and the entirely rational response is to try to get out of the market before everyone else does. Hence the stampede. It’s not the busts that are the problem. It’s the booms.

    The big error is the persistent myth that money can create wealth. But it cannot. Banking and financial services are services to actual wealth creating industries, and as such can only receive some portion of the final return on investment by entrepreneurs, just as, say, employment agencies render a service to wealth creating industries, but can only realise some (rather small) proportion of the final consumer value created.

    We have had particularly a myth since the 80s that finance is, or can be, “the engine of the economy”. It isn’t, and cannot be. It helps enable production by securing finance for entrepreneurs, but that is all. It cannot generate any economic growth by itself, any more than employment agencies can. The result of this pernicious myth is a banking industry that is too big, trying to lend more money than the economy can support, promising an effective ROI that cannot be actually delivered, and is effectively the one industry that refuses to ever downsize to reality, holding the threat of destroying money itself over the heads of the rest of us.

    The recent crash wasn’t some random arbitrary stampede. It was the free market trying to destroy dysfunctional, failed banking businesses and contract the banking share of the market down to its free market level. Thus, what John B would call the “libertoonian” argument is that, in a free economy, banking would be a useful and essential service industry, but it would be considerably smaller and quieter and considerably more dull, and the greatest profits would go to those economic agents who provide the greatest value to consumers, not the state-backed cartel who connive with government to be the managers of the fiat money machine. Unless and until we can break the feedback loop of banking and State debt that generates new money, we will never get a metastable economy. It’s not the busts we should be worrying about. It’s the booms.

  15. If greedy bankers cause crises, we would have a crisis every week.

    How about

    If the moon caused solar eclipses, we would have a solar eclipse every week?

    However, the notion that bankers do foolish things because they can count on the government to bail them out if it goes wrong is mistaken. Bankers don’t think it’s going to go wrong.

  16. “[Community Reinvestment Act] loans performed far better than non-CRA loans.”

    Er, link please? Otherwise I’m going to assume that’s a whopping Big Lie.

  17. Maturity Tranformation is NOT necessary. This is a Big Lie. http://unqualified-reservations.blogspot.co.uk/2008/09/maturity-transformation-considered.html

    “So, basically, if you believe that MT is economically productive, you believe it’s economically productive for the government to print money and lend it out. Which may well be the case. The only question is why you prefer that this be done indirectly in a dangerous and unstable way, rather than openly, directly and stably.”
    http://econlog.econlib.org/archives/2008/10/monetary_instit.html

  18. Maturity Tranformation is NOT necessary. This is a Big Lie.

    Just because somebody says something on the internet does not mean it is true. It applies just as much to a computer programmer’s opinions on economics to a leftwing dilettante former accountant’s opinions on tax.

  19. @Paul

    You are right – the bankers never believed it was going to go wrong and never even thought about government support, except when it did actually all go wrong.

  20. IanB

    You didn’t read what I said properly, did you? I said that at the individual level fear is rational. But at the aggregate level, the result of people acting on their fears is a stampede – a crash. Nothing you have said contradicts that.

    Nor do I disagree with you about booms. I wasn’t talking about them. I was talking about the cause of crashes, which is fear. I would go on to add, that booms are caused by greed. Both emotions are rational at an individual level, but the problem is the human herding instinct, which leads us to follow each other like cattle whenever we see something dangerous or something tasty.

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