Gary Gorton's forthcoming book
By Arnold Kling
It is called Misunderstanding Financial Crises, a title that may be unintentionally ironic. As you probably know, Gorton is famous for treating the crisis as a “run on the shadow banking system” that had very little real basis.
The deterioration of house prices and defaults in the subprime mortgage market were not enough to cause a systemic crisis by themselves.
Could have fooled me. Gorton’s is probably the only treatment of the crisis that you will read in which the housing boom/bust and underwater mortgages are not a central issue. For Gorton, the financial losses were caused almost entirely by mindless panic, not by bad loans.
Gorton comes across as a fan of bailouts.
No society with a market economy has ever chosen (intentionally) to liquidate its banking system
He says, in effect, that the government always bails out banks, and it is better off doing it sooner rather than later.
[In January of 2008] I advocated that Freddie Mac and Fannie Mae refinance all subprime mortgages at their initial teaser rate. This was eight months before Lehman failed. I am convinced that had this been done the crisis could have been largely avoided.
Should others share Gorton’s conviction? I do not. Freddie Mac and Fannie Mae were not in a position to bail out borrowers. Moreover, the problem for borrowers was not the interest rate. The problem was that borrowers were dependent on ever-rising house prices, and prices had stopped rising.
While it would be best to design a system of bank regulation that avoids crises, this also runs the risk of financial repression. There may be large costs to avoiding crises altogether.
This passage concludes one chapter that seemed to me to stand apart from others. Elsewhere in the book, Gorton praises the period between the mid-1930’s and 2007 as a “Quiet Period,” during which deposit insurance and restrictions on bank competition reduced financial crises. Was the “quiet” purchased at the expense of financial repression and foregone growth? He never connects this chapter with other chapters.
The government did not know of the existence of the shadow banking system. Further, in light of the testimony of dealer bank CEOs before the Financial Crisis Inquiry Commission, it is doubtful if even the dealer banks understood the changes to the financial system
It would be interesting to read the fourth edition of Marcia Stigum’s Money Market. I read an earlier edition back when I worked at the Fed in the early 1980s, and it explained the repo market quite well. While I am sympathetic to the view that there were cognitive shortcomings among market participants and regulators, I am not sure that it is fair to say that there was no awareness of the way that the system functioned.
John Taylor will not agree with this:
there cannot be inflexible rules that the central bank must follow in crises. During noncrisis times most economists think that the central bank should focus on fighting inflation based on rules rather than discretion. But in crisis times it is the opposite. Central banks must have discretion, sometimes to take unprecedented actions.
And I will not agree with this:
The overarching goals of the proposal [by Gorton and his colleague Andrew Metrick] are to bring securitization under the regulator umbrella and to provide a system of collateral production that can back repo without being vulnerable to runs…Re-creating confidence in the shadow banking system is essential for economic growth.
As you know, I think that mortgage securitization could disappear without being missed.
In Not What They Had in Mind, I said that the crisis included four components: bad bets (mortgage loans that should not have been made); excessive leverage; domino effects; and 21st-century bank runs.
Gorton insists that the bad bets and excessive leverage were not important. He refuses to see the period leading up to 2007 as one of financial excesses. His policy prescriptions offer no mechanism for limiting the financial sector’s role in the economy, even as they call for unrestricted discretionary bailouts.
There is much that one can learn from reading this book. However, his analysis is so impaired, and his air of smugness is so strong that it is more likely to put off than to convince his fellow economists.