The Investor's Shelf — one book
Misunderstanding Financial Crises

Misunderstanding Financial Crises

Gary Gorton
2012
T2 278 pages · about 4h 38m to read OL16564454Wgoodreads

Why short-term debt is information-insensitive until suddenly it is not.

Summary

Gary Gorton argues that the 2007 and 2008 crisis was a bank run, that it was the same kind of event as the panics of the nineteenth century, and that economists failed to see it coming because they had stopped studying banking panics. His explanation for that failure is that the United States went from 1934 to 2007 without one, a period he calls the Quiet Period, during which the profession concluded that panics were a solved problem.

The analytical core concerns what he calls information-insensitive debt. Bank deposits, and their modern equivalents in repurchase agreements and asset-backed commercial paper, work as money because nobody needs to investigate their value. Once holders begin to doubt, they must investigate, and the debt stops functioning as money. A run is what happens when short-term debt becomes information-sensitive: holders withdraw or demand more collateral, not because they know the assets are bad but because they no longer know they are good. Gorton argues the 2007 event was a run on repo and on asset-backed commercial paper by institutional investors, structurally identical to depositors queuing at a bank.

His policy implication is that regulation should aim to keep short-term debt information-insensitive rather than to increase transparency, which he argues can precipitate runs rather than prevent them. That conclusion is contested, since it points toward guarantees and away from disclosure. Critics also argue that Gorton underweights the underlying deterioration in mortgage credit quality and treats the run as if its trigger were arbitrary. The book is short, non-technical, and the clearest statement of the run interpretation of the crisis.

Key takeaways 7

  1. The 2007 and 2008 crisis was a run on short-term wholesale debt, structurally identical to a nineteenth-century bank run.
  2. Bank debt functions as money only while holders have no reason to investigate its value, and a run begins when that condition breaks.
  3. The United States experienced no banking panic between 1934 and 2007, which led economists to stop studying them.
  4. Repurchase agreements and asset-backed commercial paper served as deposits for institutional investors and had no equivalent insurance.
  5. Increased transparency about bank assets can precipitate a run rather than prevent one, because it makes the debt information-sensitive.
  6. Deposit insurance ended banking panics in the United States, which shows that the run problem is solvable by guarantee.
  7. Gorton argues that financial innovation reliably recreates uninsured short-term debt outside whatever perimeter regulation has drawn.

Who should read it

Investors and policymakers who want a compact theory of banking panics that applies equally to the 1870s and to 2008.

Where it sits in the reference 2

Assets
Philosophy

Similar books 6

Chosen by shared topics, the entries that hold them, and the people who recommended both.

A History of Interest Rates
A History of Interest RatesSidney Homer, Richard Sylla
Lombard Street
Lombard StreetWalter Bagehot
Slapped by the Invisible Hand
Slapped by the Invisible HandGary Gorton
21st Century Monetary Policy
21st Century Monetary PolicyBen S. Bernanke
A Financial History of Western Europe
A Financial History of Western EuropeCharles P. Kindleberger
A History of Money and Banking in the United
A History of Money and Banking in the United StatesMurray N. Rothbard