Misunderstanding Financial Crises: Why We Don't See Them Coming

Overview

Before 2007, economists thought that financial crises would never happen again in the United States, that such upheavals were a thing of the past. Gary B. Gorton, a prominent expert on financial crises, argues that economists fundamentally misunderstand what they are, why they occur, and why there were none in the U.S. from 1934 to 2007.

Misunderstanding Financial Crises offers a back-to-basics overview of financial crises, and shows that they are not rare, idiosyncratic events ...

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Misunderstanding Financial Crises: Why We Don't See Them Coming

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Overview

Before 2007, economists thought that financial crises would never happen again in the United States, that such upheavals were a thing of the past. Gary B. Gorton, a prominent expert on financial crises, argues that economists fundamentally misunderstand what they are, why they occur, and why there were none in the U.S. from 1934 to 2007.

Misunderstanding Financial Crises offers a back-to-basics overview of financial crises, and shows that they are not rare, idiosyncratic events caused by a perfect storm of unconnected factors. Instead, Gorton shows how financial crises are, indeed, inherent to our financial system. Economists, Gorton writes, looked from a certain point of view and missed everything that was important: the evolution of capital markets and the banking system, the existence of new financial instruments, and the size of certain money markets like the sale and repurchase market. Comparing the so-called "Quiet Period" of 1934 to 2007, when there were no systemic crises, to the "Panic of 2007-2008," Gorton ties together key issues like bank debt and liquidity, credit booms and manias, moral hazard, and too-big-too-fail—all to illustrate the true causes of financial collapse. He argues that the successful regulation that prevented crises since 1934 did not adequately keep pace with innovation in the financial sector, due in part to the misunderstandings of economists, who assured regulators that all was well. Gorton also looks forward to offer both a better way for economists to think about markets and a description of the regulation necessary to address the future threat of financial disaster.

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Editorial Reviews

From the Publisher
"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.
Mr. Gorton brings to the question a combination of historical perspective, academic expertise and, unlike most academics, personal experience...his book is a refreshing and valuable account that should take its place among the essential reading of any student of crises." —The Economist

"The book offers essential insights into the mysteries of the recent financial crisis. Gorton has the rare depth of understanding to explain the elements and similarities of a wide array of historical crises. Fascinating reading."—Robert J. Shiller, Arthur M. Okun Professor of Economics, Yale University, author of Irrational Exuberance and Finance and the Good Society

"Professor Gorton has produced an excellent, readable and incisive account of the recent financial crisis in historical perspective. We, as economists, have an obligation to understand our own profession's failings in the policy framework leading up to the financial crisis. Gorton shows us that blind faith in mathematical models of idealized economies can lead to blind spots in regulators' view of economic reality. This phenomenon had disastrous consequences during the 2008-2009 financial crisis, as intricately documented in this book. The book presents important lessons for how financial regulatory reform should be designed and implemented in the future. In addition, it provides a cautionary tale for economists to rethink their approach to policy advice more generally."—Justin Yifu Lin, Chief Economist and Sr. Vice President, World Bank

"Financial Crises have been a feature global finance for centuries, but economists and other analysts still struggle with the subject. If anything, since the events of 2007-2009 and the more recent crisis in Europe our fears have only grown larger. In this timely new book Gary Gorton reviews history, theory and evidence concerning financial crises, their causes and possible research and policy responses. It is at the same time very thorough and very interesting, and will no doubt appeal to academics and practitioners." —Arminio Fraga Neto, former President, Central Bank of Brazil, Founder, Gavea Investimentos

"An important book." - The Financial Times 3/12/12

"Written in a very accessible style, the book makes the reader not only question what caused the financial crisis of 2008-09 but also think analytically about what made possible the moderation or the 'Quiet Period' from 1934 to 2007, during which time there were 'no systemic financial crises.' His book provides immensely useful information about the policies that led to the crisis. This volume is must reading for undergraduates in economics and finance as well as business leaders and future policy makers. Graduate students, faculty, and general readers will find it a pleasure to read. Essential."—CHOICE

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Product Details

  • ISBN-13: 9780199922901
  • Publisher: Oxford University Press
  • Publication date: 11/2/2012
  • Pages: 296
  • Sales rank: 309,864
  • Product dimensions: 6.10 (w) x 9.30 (h) x 0.40 (d)

Meet the Author

Gary B. Gorton is the Frederick Frank Class of 1954 Professor of Finance at the Yale School of Management. He is the author of Slapped by the Invisible Hand: The Panic of 2007.

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Table of Contents

Preface
I. Introduction
II. Creating the Quiet Period
III. Financial Crises
IV. Liquidity and Secrets
V. Credit Booms and Manias
VI. The Timing of Crises
VII. Economic Theory without History
VIII. Debt During Crises
IX. The Quiet Period and Its End
X. Moral Hazard and Too-Big-To-Fail
XI. Bank Capital
XII. Fat Cats, Crisis Costs, and the Paradox of Financial Crises
XIII. The Panic of 2007-2008
XIV. The Theory and Practice of Seeing
Bibliographic Notes
Notes
References
Index

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Interviews & Essays

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.

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