“Slapped in the face by the invisible hand”

“Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007” is Yale University economist Gary B. Gorton’s explanation for the financial crisis of 2007 and 2008.

The paper was prepared for the Federal Reserve Bank of Atlanta’s 2009 Financial Markets Conference: Financial Innovation and Crisis, held May 11-13, 2009, on Jekyll Island.  (A year later it would become the first chapter in his book, “Slapped by the Invisible Hand: The Panic of 2007.”)

From the paper:

The “shadow banking system,” at the heart of the current credit crisis is, in fact, a real banking system – and is vulnerable to a banking panic. Indeed, the events starting in August 2007 are a banking panic. A banking panic is a systemic event because the banking system cannot honor its obligations and is insolvent.

Unlike the historical banking panics of the 19th and early 20th centuries, the current banking panic is a wholesale panic, not a retail panic. In the earlier episodes, depositors ran to their banks and demanded cash in exchange for their checking accounts. Unable to meet those demands, the banking system became insolvent. The current panic involved financial firms “running” on other financial firms by not renewing sale and repurchase agreements (repo) or increasing the repo margin (“haircut”), forcing massive deleveraging, and resulting in the banking system being insolvent.

The earlier episodes have many features in common with the current crisis, and examination of history can help understand the current situation and guide thoughts about reform of bank regulation. New regulation can facilitate the functioning of the shadow banking system, making it less vulnerable to panic.

Economists view the world as being the outcome of the “invisible hand,” that is, a world where private decisions are unknowingly guided by prices to allocate resources efficiently. The credit crisis raises the question of how it is that we could get slapped in the face by the invisible hand. What happened?

Many private decisions were made, over a long time, which created the shadow banking system. That system was vulnerable to a banking panic. The U.S. had a banking panic starting in August 2007, one that continues today.

But banking panics, you say, like the one in the movie “It’s a Wonderful Life,” don’t happen anymore. Indeed, until these recent events, most people did not think of banking panics as something to be concerned about. After all, the panics of the Great Depression are a dim memory. Since 1934 when deposit insurance was adopted, until the current panic – a span of almost 75 years – there had been no banking panics. …

What gave us almost 75 years of relative quiet in banking? What has changed? How could problems in one part of the housing sector cause a banking panic in the 21st century? The banking system metamorphosed in the last twenty-five to thirty years and this transformation re-created the conditions for a panic.

But, what does that mean exactly? What is the “shadow banking system”?

Understanding that the shadow banking system is, in fact, real banking and that current events constitute a banking panic is vital to thinking about the future of the financial system.