Who has the best narrative to explain the crisis?



Economic journalist and writer David Warsh says Yale University professor Gary Gorton may have the best explanation of the financial crisis of 2007 and 2008.

Writing in The Commentary, a report from The Investment Fund for Foundations, Warsh remembers Peter Bernstein, whom he calls “America’s premier financial journalist.” Bernstein, who died in 2009, developed in his 1992 book “Capital Ideas: The Improbable Origins of Modern Wall Street” a narrative to explain why the stock market fell in 1974 and how investment thinking evolved after that.

Then Warsh writes:

But now he’s gone.

Where, then, to turn for an authoritative,
disinterested, reader-friendly narrative of the
recent crisis?

The next best thing today to Bernstein may be
a 58-year-old Yale economist and economic
historian named Gary Gorton. Certainly his
“Slapped By the Invisible Hand: The Panic of
2007,” which appeared last spring, is the most
cogent analysis to appear so far about what
happened between the first tremors in subprime
securities and the moment eighteen months later
when things came crashing down. …

Federal Reserve Board Chairman Ben Bernanke, asked by a member of the Congressional commission
investigating the crisis about the most important
and unappreciated work, cited Gorton’s writings,
“where he is pretty clear to identify the analogies
between what happened to the shadow banking
system and classic bank runs – 19th century-style
bank runs.”

Gorton was among the handful of economists
to whom the Federal Reserve System turned
to explain the crisis in real time, at two highlevel
conferences, each sponsored by one of its
regional banks – the first in August 2008, on
the eve of the crisis, at the annual symposium
of central bankers at Jackson Hole, Wyoming;
the second, six months later, after the worst had
passed, on the south Georgia resort of Jekyll
Island (where blueprints for the Fed had been
drawn a century before). The result is a record
of what top authorities knew, or in a better world
should have known, as they went into that terrible

At Jackson Hole, Gorton explained that the
August panic of the year before had not been a
classic run on the banks, in that the traditional
banking system was not involved, as it had
been in, say, 1907. Instead, he said, “we’ve
known for a long time that the banking system
was metamorphosing into an off-balance sheet
and derivatives world – the shadow banking
system.” And it was that August when a group
of quantitative hedge funds suddenly found
themselves in a strange “no trade zone” in which
“no one would trade with you simply because
you wanted to trade with them.” As it happened,
the situation was resolved with no government
involvement. A couple of funds went broke and
were quickly acquired by others. The outside
world barely noticed.

Gorton then went on to explain in considerable
detail how a bursting house-price bubble could
give rise to a systemic crisis. He led his listeners
on an unaccustomed tour of the securitization
industry, meaning the process by which
previously illiquid loans – not just mortgages
but receivables of all sorts, commercial lending,
student loans, credit card debt – are pooled,
extensively repackaged, and sold into securities
markets. He pointed to many features, once
strange, that are now familiar to crisis buffs:
diagrams of the allocation of interest among
tranches of collateralized debt obligations, the
unusual properties of ABX indices of subprime
mortgage-backed securities, an account of how
the run started in such back alleys as asset-backed
commercial paper conduits and special investment
vehicles. …

The mood of the Jackson Hole meeting
was strange, Gorton reported. Despite “an
undercurrent of anxiety,” he later wrote,
“participants did not act like we were in the middle
of a terrible crisis that seemed out of control and
not understood.” Instead, the dominant narrative
remained misaligned incentives, the “originateto-
distribute” story wherein banks originated
loans, then off-loaded the risk. Most apparently
still hoped for a soft landing….

Gorton was highly qualified to make the call. For
one thing, he was an economic historian. His 1983
dissertation at the University of Rochester was
a history of nineteenth-century banking panics.
(Before taking up economics, he had driven cabs
and worked as a union organizer after abandoning
his quest for a Chinese literature Ph.D.) Then, too, he had cut his teeth on monetary policy, working for a time in the research department of the Philadelphia Federal Reserve Bank before teaching for 24 years at the Wharton School of the University of  Pennsylvania. (He moved to Yale in 2008.) Above all, though, he was an industry insider. For ten years, he consulted extensively to the Financial Products unit of the insurance giant American International Group, building models for the firm in order to evaluate structured credit, credit derivatives, and commodity futures.

When AIG collapsed, Gorton was among those
on the receiving end of lawsuits and even death
threats. He kept writing throughout and during
2009 put together his two Fed conference papers
without editing (except for splitting the Jackson
Hole one into two parts), combined those with
a third paper he had written in the mid ’90s on
the rise of the shadow banking industry, added
an introduction and an afterword (“A Note to
Those Reading This in 2107”) and a timeline of
developments and sent Slapped By the Invisible
Hand out into the world, where it has been
mostly ignored.

See Warsh’s column for an extensive discussion of Gorton’s theory.


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