Interviews

Q: Why should anyone care about another book about financial crises?

A: There are many books on the financial crisis because the subject of what happened is very important. If we are to avoid another financial crisis, then we must understand the details of what happened. My perspective is different from other authors. I have been studying financial crises for thirty years, as a professor at the Wharton School and now at Yale. But, I also saw the crisis as an eye-witness because I was a consultant to AIG Financial Products for 12 years.

Q. So, if your perspective is unique, what do you say happened?

A. Despite everything that has been written on the subject, this question, though the most basic and fundamental of all, seems very difficult for most people to answer. They can point to the effects of the crisis, namely the failures of some large firms and the rescues of others. People can point to the amounts of money invested by the government in keeping some firms running. But they can't explain what actually happened, what caused these firms to get into trouble. Where and how were losses actually realized? What actually happened?

There was a banking panic, starting in July and August 2007. In a banking panic, depositors rush en masse to their banks and demand their money back. The banking system cannot possibly honor these demands because they have lent the money out or they are holding long-term bonds. To honor the demands of depositors, banks must sell assets. But only the Federal Reserve is large enough to be a significant buyer of assets.

The banking panic of the recent crisis centered on another form of bank debt — sale and repurchase agreements, called the “repo” market. About $1.2 trillion was withdrawn from banks during this panic.

Q: This seems a lot different from other explanations of the crisis—why do you think this is the case?

A: The panic in 2007 was not observed by anyone other than those trading or otherwise involved in the capital markets because the repo market does not involve regular people, but firms and institutional investors. So, the panic in 2007 was not like the previous panics in American history in that sense (like the Panic of 1907, shown below, or those of 1837, 1857, 1873, 1893 and so on) in that it was not a mass run on banks by individual depositors, but instead was a run by firms and institutional investors on financial firms. The fact that the run was not observed by regulators, politicians, the media, or ordinary Americans has made the events particularly hard to understand. It has opened the door to spurious, superficial, and politically expedient “explanations” as well as demagoguery.

Q: What was “misunderstood” as your title suggests?

A: The concept of a “financial crisis” was misunderstood by economists, who are the experts that should offer clear policy advice. But, economists simply did not think that it was possible for a financial crisis to occur again in the United States. So, they were unprepared. Why? Because they do not understand that financial crises are an inevitable consequence of short-term bank debt. To see this one must understand financial history, but this is not viewed as important in economics curricula.