Gary Gorton,
Oxford University Press,
278 pages, $29.99
Ben Bernanke, the chairman of the Federal Reserve, was once asked for his recommended reading on financial crises. He named the work of Gary Gorton, a Yale University professor. "Misunderstanding Financial Crises" demonstrates why.
Gorton brings to the question a combination of historical perspective, academic expertise and, unlike most academics, personal experience: He was a consultant on financial products from 1996 to 2008 for AIG, the giant insurance company that was bailed out in 2008.
All systemic financial crises, he argues, are the result of a broad loss of confidence in bank debt. Unlike most private debt contracts, bank liabilities are meant to be riskless; customers assume they can get back 100 cents on the dollar on demand.
In the early 1800s those liabilities consisted of privately issued notes convertible on demand to specie (gold or silver). After national banknotes were introduced in America in the 1860s bank liabilities were current-account deposits, the financial innovation of their day. During a generalized panic the banking system did not have enough specie or banknotes to meet all the redemption requests.
By 2007 the huge growth in financial innovation had led many "shadow" banks to fund themselves with overnight "repo" loans backed by high-quality collateral or asset-backed commercial paper. The recent panic stemmed from a run on those liabilities.
Gorton rejects the most popular explanations for the crisis: inadequate capital of financial institutions, moral hazard and "too-big-to-fail" institutions. But he presses his case a little too enthusiastically. Inadequate capital certainly explained why many, if not all, financial institutions foundered in 2007 and 2008. Similarly, Fannie Mae and Freddie Mac could not have grown so big and leveraged without moral hazard. That said, his book is a refreshing and valuable account that should take its place among the essential reading of any student of crises.
THE ECONOMIST
