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

Gary B. Gorton
3.5 out of 5 stars  See all reviews (2 customer reviews)
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Book Description

27 Dec 2012
Prior to the financial crisis of 2007-2008, economists thought that no such crisis could or would ever happen again in the United States, that financial events of such magnitude were a thing of the distant past. In fact, observers of that distant past—the period from the half century prior to the Civil War up to the passage of deposit insurance during the Great Depression, which was marked by repeated financial crises—note that while legislation immediately after crises reacted to their effects, economists and policymakers continually failed to grasp the true lessons to be learned.

Gary Gorton, considered by many to be the authority on the financial crisis of our time, holds that economists fundamentally misunderstand financial crises—what they are, why they occur, and why there were none in the U.S. between 1934 and 2007. In Misunderstanding Financial Crises, he illustrates that financial crises are inherent to the production of bank debt, which is used to conduct transactions, and that unless the government designs intelligent regulation, crises will continue. Economists, he 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. Delving into how such a massive intellectual failure could have happened, Gorton offers a back-to-basics elucidation of financial crises, and shows how they are not rare, idiosyncratic, unfortunate events caused by a coincidence of unconnected factors. By looking back to the <"Quiet Period>" from 1934 to 2007 when there were no systemic crises, and to the <"Panic of 2007-2008,>" he brings together such issues as bank debt and liquidity, credit booms and manias, and moral hazard and too-big-too-fail, to illustrate the costs of bank failure and the true causes of financial crises. He argues that the successful regulation that prevented crises did not adequately keep pace with innovation in the financial sector, due in large part to economists' misunderstandings. He then looks forward to offer both a better way for economists to conceive of markets, as well as a description of the regulation necessary to address the historical threat of financial crises.

Frequently Bought Together

Misunderstanding Financial Crises: Why We Don't See Them Coming + The Bankers' New Clothes: What's Wrong with Banking and What to Do about It + After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead
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Product details

  • Hardcover: 296 pages
  • Publisher: OUP USA (27 Dec 2012)
  • Language: English
  • ISBN-10: 019992290X
  • ISBN-13: 978-0199922901
  • Product Dimensions: 23.6 x 15.7 x 2.3 cm
  • Average Customer Review: 3.5 out of 5 stars  See all reviews (2 customer reviews)
  • Amazon Bestsellers Rank: 126,477 in Books (See Top 100 in Books)
  • See Complete Table of Contents

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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)

[An] important book. A Financial Times Book of the Year. (Financial Times It is full of interesting ideas and original thinking, and is warmly recommended to anyone interested in the financial crisis.)

About the Author

The Frederick Frank Class of 1954 Professor of Finance at the Yale School of Management

Inside This Book (Learn More)
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Front Cover | Copyright | Table of Contents | Excerpt | Index
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Most Helpful Customer Reviews
3 of 4 people found the following review helpful
5.0 out of 5 stars A five star book if ever I read one 17 Jan 2013
Format:Hardcover|Verified Purchase
Oh I absolutely cannot let this book sit on your virtual shelves without more stars as, for me, it is THE BEST book I have read with respect to financial crises. What Jamie said to Dick when they secretly met in John's apartment at the Four Seasons hotel is entertaining, but it will do squat to help ensure they or their successors don't have to do it all over again any time soon (like in my lifetime).

It got to the point with this book that I became embarrassed at the number of comments I was making in the Kindle margin.

"Whatever it takes" is not a new mantra invented by Fed Chairman Ben Bernanke to get the recently crisis ridden financial system back on it's feet -- it's age old.

And for what it's worth, I think Gary Gorton is spot on with respect to what he pin-points as the key transmission mechanisms through which the initial sparks of fire subsequently engulfed the entire system.
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17 of 30 people found the following review helpful
2.0 out of 5 stars Disappointing Rehash 8 Dec 2012
By John S
Format:Kindle Edition
This book may be marginally interesting for someone who hasn't read much about the financial crisis but those who have will find little new.
The author seems to suffer from the misconception that what economists understand about the finance industry is important. But this just isn't so. The crisis wasn't caused by lack of knowledge but rather by willful collusion amongst industry insiders coupled with a total lack of understanding on the part of the world's central banks regarding the impact of China on the economy.

The fact that the crisis was an emerging phenomenon that arose from the interaction of many players makes it hard to understand and is the reason why simplistic account such as this fail. Although the outlines of what went wrong are by now pretty clear.

Central Bankers misunderstood the slow rise in prices as indicating that inflation was well under control; what they missed was that the entry of China into the global economy should have led to a fall in prices. Interest rates were then kept too low to long.
This created a rush for yield, investors would buy anything that had higher yields. Bankers rushed to fill this gap by creating securitised mortgages and ordinary citizens cooperated by rushing to buy houses that could only go up in value in an environment of artificially easy money. And finally the rating agencies knowingly blessed the results so the mortgages could be sold as AAA.
Politicians stood by while this was happening because their voters were happy with ever increasing house prices and their campaign funds were filled with contributions from the banks. Regulators were understaffed and underfunded and reined in by their political masters.
Given this dynamic, the failure of economists to understand that markets aren't efficient is a tiny insignificant part of the problem. Bankers and traders have always understood more about markets than academic economists and probably always will.
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Amazon.com: 3.4 out of 5 stars  17 reviews
30 of 32 people found the following review helpful
4.0 out of 5 stars A Worthwhile Read 27 Nov 2012
By George Hariton - Published on Amazon.com
Format:Hardcover|Verified Purchase
Gorton makes four very important points:

(1) Financial crises always arise when the public (individuals or businesses) lose faith in bank debt. According to Gorton, creating debt is the main business of banls. It is this debt that enables our economy to function. Unfortunately, in times of rapid expansion, banks create debt too quickly and so become fragile.

(2) Financial crises are always characterized by bank runs. These can be very visible, e.g. depositors lining up to get their money back. Or they can be invisible, e.g. lenders in the shadow banking system, who typically lend for a day or so at a time, refusing to roll over the loans to suspect banks. It follows that the real problem is not banks that are under-capitalized, but banks that are illiquid, i.e. they don't have enough cash on hand to meet demands. (They could have lots of illiquid assets, but so what?)

(3) The banking sector is so essential to the economy that governments will not let it go under. In this sense, banks have been "too big to fail" for at least two centuries. The tool used by the government evolves over time -- suspensions of withdrawals and "bank holidays" in the nineteenth and early twentieth centuries, the Fed as lender of last resort and deposit insurance in the twentieth century, bailouts via purchase of toxic assets in the twenty-first. Each time the popular reaction is fury: Populists wanted to hang the bankers a hundred and fifty years ago, a hundred years ago, etc.

(4) Both fortunately and unfortunately, financial innovations allow banks to create new forms of bank debt to satisfy the growing demand for such debt. Asset-backed securities and CDOs are just the latest in a long line, e.g. checking accounts, credit cards, and so on. Government is usually one or two steps behind. Indeed, with the disappearance of the physical queue of depositors clamoring to be paid, the government now has difficulty recognizing when a bank run occurs, and tends to intervene too late.

Gorton's solution is more regulation. That may be controversial, but Gorton's case is very well argued. He examines in detail financial crises over the past two hundred years (although he limits himself almost exclusively to the U.S.). The lessons he draws lead him to the above conclusions, plus a number of other insights.

Unfortunately, as with his previous book, Slapped by the Invisible Hand, this book is very badly written and could use a strong editor or even a rewrite. It is repetitious in many places, the author jumps around a bit, and may sentences are just plain awkward. When he quotes at length a nineteenth-century author, that comes as a relief. For this reason, I'm giving it four stars instead of the five that the content richly deserves.
12 of 13 people found the following review helpful
4.0 out of 5 stars Useful Historical Perspective 2 Nov 2012
By Ira E. Stoll - Published on Amazon.com
If there's a conventional wisdom about how to respond to the financial crisis, it's that banks need higher capital requirements. President Obama, in his first presidential debate with Mitt Romney, said the Obama administration had said, "banks, you've got to raise your capital requirements." Mr. Romney agreed: "you need to have leverage limits." The free-market-oriented Wall Street Journal editorial page editorializes in favor of tougher capital requirements as a "critical reform," while the left-of-center New York Times editorial page mentions the Dodd-Frank Law imposing "higher capital requirements for banks" as a reason to vote for Mr. Obama.

For that reason alone, Gary Gorton's new book is worth a look. Mr. Gorton, a professor at Yale and a former consultant to AIG Financial Products, challenges that conventional wisdom on capital requirements. "Crises are about cash and not capital," he writes. "High capital ratios cannot prevent runs." In case that is insufficiently clear, Mr. Gorton goes on, "There is almost no evidence that links capital to bank failures."

Mr. Gorton brings to bear a historical perspective along with his refreshing willingness to challenge the conventional wisdom. He says the lack of such a historical perspective is one reason that the economics profession failed to see the crisis coming: "It used to be that economics PhD programs required at least one term of economic history, but this has disappeared. Many top economics programs that previously had two or three economic historians now have none."

Among the episodes that Mr. Gorton recovers from the past are the 1857 case Livingston v. Bank of New York, in which a New York court found "the mere fact of suspension of specie payments" was not sufficient to force a bank into liquidation. Another is the 1934 case Home Building & Loan Association v. Blaisdell, in which the Supreme Court upheld the Depression-era Minnesota Mortgage Moratorium Act.

The author also has an eye for illuminating quotes when it comes to more recent events. He reminds readers that White House economic adviser Austan Goolsbee said of AIG executives, "It's almost like these guys should have gotten the Nobel Prize for evil." And that Charles Grassley, a Republican senator, suggested that AIG executives resign or commit suicide.

Given that level of hostility from government officials, it is somewhat surprising that Mr. Gorton concludes by recommending regulatory changes that "would place the government in an oversight role in the securitization and repo markets." Which government overseer would Mr. Gorton like for those markets, one wonders? Senator Grassley, or Professor Goolsbee?

The answer to that question aside, this slim and lively volume makes a useful addition to the vast library of books about the financial crisis. I learned from and enjoyed this one even though I have already read many of the others.
24 of 29 people found the following review helpful
3.0 out of 5 stars The more things change, the more they stay the same 4 Nov 2012
By S. Gentry - Published on Amazon.com
Format:Kindle Edition|Verified Purchase
Good historical perspective although almost entirely limited to the US economy and financial system. The author does a good job explaining the origins and evolution of bank notes as currency both before and after the Civil War.

As it moves into the 2008 GFC, the book describes the impprtant role of the 'repo' market and the shadow banking system. The author explains that this crisis was a run on the bank. But in this instance it was a run on banks by banks, not by individual depositors.

The moral of his story is that, since the Great Depression, financial institutions have had, do have and always must have explicit (deposit insurance) and implicit (too big to fail) backing from taxpayers.

I therefore don't understand (and the book does not explain) why bank shareholders and management get the upside while taxpayers wear the downside. If credit is a necessary public good, then why isn't it treated more like a utility---either taxpayer owned or much more highly regulated, with limited upside and limited downside?
11 of 12 people found the following review helpful
4.0 out of 5 stars Not Just Another Bank-Bashing Book 20 Dec 2012
By A. Pfeffer - Published on Amazon.com
Format:Kindle Edition|Verified Purchase
This is a highly informative analysis of American financial crises and bank runs since the 18th Century. Gorton's historical perspective, as opposed to the purely journalistic approach of most "insider" books--though he too was an insider at AIG--allows him to describe the 2007 crisis as the latest in a long series of sudden losses of public confidence in financial institutions. Gorton explains why it is hard to prevent such crises without absolutely foolproof government insurance ("bailouts") against every loss of every type on Main Street and Wall Street, a backup that is almost impossible to arrange because the government's own solvency isn't absolute. Nor is anyone else's in a money-based economy. There was no bank run in 2007 (the runs were on the investment houses) because we trust the FDIC to keep our bank deposits fully safe. I'll let you follow the details of this argument yourself, but I guarantee you will learn something.

I deduct one star because of the writing. For one thing, like most contemporary books--all of these comments apply to most contemporary books--this one seems not to have been professionally copy-edited. Sometimes it reads like a first draft. I don't mean Gorton is a bad writer. Even the most famous and skillful writers (including Shakespeare, Balzac, Dickens, Tolstoy, Stephen King, etc.) are not competent to edit their own manuscripts. Maybe there are no professional editors any more. Maybe publishers don't care to pay for them. In Gorton's case, thorough editing would have eliminated not only the misused words and confusing sentences but more importantly some of the wordiness and repetition. Again like many current books this one is probably half again as long as it needs to be to make its case. Often it seems that each sentence or even paragraph is totally unaware that other sentences or paragraphs in the book exist and have already used a certain fact or made a similar point (like the causes of bank runs). Modern non-fiction in particular often seems to lack a sense of overall organization. Like a dumbed-down documentary on the History Channel where the story begins all over again after every commercial, it's Back to Basics in every chapter.

Still, four out of five ain't bad. If you are interested in economic ideas and the real roots of the Great Recession, Gorton's book will amply reward your patience.
7 of 8 people found the following review helpful
4.0 out of 5 stars Terrific content, partly diminished by poor style and organization 12 Dec 2012
By William H. Panning - Published on Amazon.com
Format:Kindle Edition|Verified Purchase
This could have been a terrific book. What it needs is the firm hand of a good editor. Unfortunately, the first half of it reads like a collection of lecture notes loosely stitched together. Sadly, the main points are repeated over and over, and the flow of the text is interrupted with extremely lengthy quotes that often add rather little to the point being made. Many should have been footnotes, rather than part of the text.

I initially found the book difficult to read, not because of the content, but because of the poor writing style and organization. Fortunately, as the author nears the end of the book both style and organization improve markedly

That aside, what the author has to say is very important, highly relevant to understanding the financial crisis, and highly pertinent to rethinking the central questions that economics should be tackling. Sadly, too many academic economics are more concerning with impressing their academic colleagues with their mathematical prowess, displayed in papers and books that address theoretical questions with little practical relevance, but that are highly publishable, especially when reviewed by disciplinary colleagues with the same proclivities.

So I give the book three stars for style, and 5 for content. Average: four stars.

I'm usually not so critical, but the author missed a real opportunity for excellence. Here's my advice: read the first half rapidly, so as not to get bogged down, and be sure to get to the end. It is worth it.
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