Friday, October 19, 2012

Financial Crises

I just received Gary Gorton's new book, Misunderstanding Financial Crises in the mail. This is as good an account of the financial crisis as any I have seen, and adds to Gary's previous book, Slapped by the Invisible Hand. Gary has an unusually broad grasp of banking history, modern banking theory, financial theory, and the practical aspects of modern finance and institutions. Indeed, some of his consulting work placed him at the center of the financial crisis. In the late 1980s, Gary taught me that securitization was important, long before most economists had any idea what that was about. I don't agree with everything he writes, but you can learn a lot from his new book.

Lucas once said that business cycles are all alike. Gorton wants to focus on what makes financial crises all alike. His key point seems to be that, in any financial crisis, we can find a run. In the United States, bank runs were a key feature of panic episodes during the National Banking era (1863-1913) and the Great Depression. Bank runs were certainly not a feature of the recent financial crisis, but Gorton thinks that "repo runs" were essentially the same phenomenon.

Gorton's idea is that any financial entity that intermediates across maturities can be subject to a run. The Diamond-Dybvig view is that bank runs are inherent to the liquidity transformation carried out by banks. A well-diversified bank transforms illiquid assets into liquid liabilities, subject to withdrawal. Everything is fine unless depositors anticipate that others will run on the bank, in which case we find ourselves in a bad equilibrium - a bank run. In the run equilibrium, it is optimal for each depositor to run to the bank to withdraw his or her deposit, since their best hope in this equilibrium is to get to the bank before the assets are exhausted.

A shadow bank is not quite like a Diamond-Dybvig bank. A typical shadow bank holds long-maturity liquid assets and finances its portfolio by rolling over short-term repos (repurchase agreements), using the underlying assets as collateral. One might think that, because the shadow bank's assets are liquid, a run could never occur. If financial market participants are reluctant to roll over the shadow bank's repos, it can sell assets to pay off its debts. The problem arises if there is a systemic revaluation of shadow bank assets. Then, an individual shadow bank could default because new repo holders are demanding large haircuts in their repo contracts. Worse, since all shadow banks are selling assets simultaneously, the prices of assets are further depressed (a fire sale), which amplifies the repo run.

A debt contract is an efficient arrangement that works extremely well in good times. The payments required under a debt contract are non-contingent, and there is no fuss about what it means to fulfill the terms of the contract. Problems occur in default states, however, particularly when there are multiple creditors. For a bank, the coordination problem that arises in the event of default is particularly severe, given the large number of small depositors. However, coordination can be very costly even if a financial institution's creditors consist of a few other financial institutions. In a Diamond-Dybvig model, coordination is formalized as "sequential service," which inhibits communication among the bank's depositors in a rather brutal fashion. Of course, a shadow bank run really has nothing to do with creditors "lining up" at the shadow bank, so we can't take sequential service literally if we want to think of repo runs as akin to Diamond-Dybvig runs.

Coordination costs that arise in a default involving multiple creditors are reflected in legal costs, and the time that assets are tied up in litigation. In the case of banking, deposit insurance minimizes those costs in a nice way. The FDIC stands in for all creditors, thus eliminating the replication of default costs among creditors and doing away with disputes among creditors. Further, resolution occurs quickly. Of course, we all know about the fallout from insuring the liabilities of financial intermediaries. Absent constraints on risk-taking, insurance creates a moral hazard problem, whereby intermediaries take on more risk than is socially optimal.

So if, as Gorton suggests, a financial crisis is defined by widespread runs on financial intermediaries, how is that helpful?

1. Does this mean that central banks should respond to every financial crisis in the same way? Probably not. Banking panics in the National Banking era and the Great Depression were essentially currency shortages. The recent financial crisis involved a shortage of safe assets, more broadly. A currency shortage can be solved with a central bank open market purchase of government debt. A shortage of safe assets may be a problem for fiscal policy - as asset swaps by the central bank will not change the net supply of safe assets. Further, central bank lending policies may depend on the particulars of the crisis.

2. If we think of a financial crisis as a run problem, and draw an analogy to banking and deposit insurance, this must mean we should insure everything that looks vaguely like banking. Moral hazard everywhere. Great.

3. One of the lessons of the financial crisis is that financial factors are important. Surprisingly, many people once thought otherwise, and some continue to think so. But the importance of financial factors is not confined to the events we want to call "financial crises." It seems wrongheaded to take episodes in history and put them in "crisis" and "non-crisis" bins.

You can see how fussing over what is a financial crisis and what is not can be unproductive. Case in point:

1. Reinhart and Rogoff define a financial crisis in a particular way, and argue that there is a regularity in the data. Recoveries after financial crises are protracted. People use that "fact" in different ways. Jim Bullard wants to argue that the Reinhart-Rogoff regularity tells us that the Fed should not held responsible for the slow recovery. Paul Krugman wants to use the Reinhart-Rogoff regularity to absolve the Obama administration. Of course, he is walking a fine line here as, in contrast to Bullard (apparently) he seems to think that appropriate monetary and fiscal policy would have left Reinhart and Rogoff with no regularity to talk about.

2. Mike Bordo and Joe Haubrich define a financial crisis differently (from Reinhart and Rogoff) and argue that, in the United States, it's hard to argue that the Reinhart/Rogoff regularity is in the data. Sometimes we see it. Sometimes we don't. John Taylor picks up on this. Like Krugman, he has an ax to grind - different ax though. According to Taylor, things are worse than they should be because of you-know-who.

Taylor does point out something useful, though, and quotes Bordo:
The mistaken view comes largely from the 2009 book “This Time Is Different,” by economists Carmen Reinhart and Kenneth Rogoff, and other studies based on the experience of several countries in recent decades. The problem with these studies is that they lump together countries with diverse institutions, financial structures and economic policies.
That's important. The U.S. financial system is unique in many ways. It still has many small banks; U.S. financial regulation is unusually complicated, with a confusing patchwork of overlapping regulatory authority; the U.S. supplies the world's reserve currency; the Fed intervenes in different ways because of peculiarities in our financial markets. The comparison with Canada is useful. Canada and the U.S. are similar in many ways, but it is difficult or impossible to find anything that Reinhart-Rogoff or Bordo-Haubrich would call a financial crisis, in all of Canadian history. How come? They have debt contracts, banking, and financial intermediation across maturities in Canada. Why no panics?

Why indeed. Definitions and data give us something, but they can't substitute for theories that can help us organize our thinking about the data. The immediate question is whether or not the monetary and fiscal authorities in the United States are doing the appropriate things. There are good reasons to think that recessions are not alike, and that the most recent recession has features that are different from previous ones in the United States - and different in important ways from episodes where we think that there was some element of "financial crisis." Even if we could figure out the Great Depression, and understood completely the policies that would have been appropriate at the time, that would be no guarantee of success under current conditions.


  1. Here is the response of Reinhart and Rogoff to Taylor.

  2. Do you really think that Taylor has an ax to grind? Obviously he's a conservative, but I don't think of him as dogmatic or partisan like Krugman. From what little I've seen, I don't think his political leanings affect his economics.

    1. Maybe not. The approach is very different from Krugman's. It's his opening paragraph that I think gives him away:

      "People are looking for answers to why the economy is growing so slowly. Is the answer that economic growth is normally weak following deep recessions and financial crises, as, for example, Kenneth Arrow argued in the presidential election event with me this week at Stanford? Or is poor economic policy the answer, as I argued?"

      He's being a bit indirect, but my understanding is that he wants to frame the issue as: The recovery is weak. There are two hypotheses: (i) The recovery is weak as that is just a feature of financial crises; (ii) The economy is weak because it is Obama's fault.

      The problem is that there is much more to it than that. For example, the recovery could be weak for reasons that have nothing to do with the financial crisis, but are related to long-term changes in the sectoral composition of employment and output. Maybe both Krugman and Taylor want to give too much credit to policy in determining the outcome here.

    2. Taylor worked for Bush. Doesn't Taylor also advise Romney? Is he advocating the position of Romney or of himself? Does he stand to gain from a Romney election?

      Krugman is not in the same position. His bread is not buttered by Obama.

    3. Krugman's marginal utility of income is low, and he has shown no interest in policy appointments. In Krugman's mind, I'm sure he thinks that Obama's re-election would benefit us all. The key point is that neither Taylor nor Krugman are primarily interested in these issues from the viewpoint of cold-hearted scientists.

    4. Follow the money, my friend.

      Blogs are not the place of science. That applies to Krugman and to you.

      Where is the cold-hearted science that is useful for the mess we are in? We certainly do not have an economics profession insisting on a scientific approach to our mess.

      Somebody please help me rationalize why we want a private equity guy in the white house who wants to utilize the same policies that are doing very poorly in the UK. I guess I should call Taylor, Mankiw or Hubbard. Perhaps, Mankiw will explain to me how tax cuts will pay for themselves as he is now paid to contradict himself.

  3. This is a very good post. I have a couple points. You seem to skirt by the issue of insolvency here. It seems to me that financial crises are sometimes caused by runs and sometimes cause runs. 2008 seems to me to be the latter case. The underlying problem was mass insolvency of households caused by falls in housing prices (and debts taken on in earlier years that pushed up those housing prices) that then transferred that insolvency to financial institutions that were levered up either on those household liabilities (through securitization) or referencing those securities (credit default swaps) or even just against other financial institution's liabilities who were somehow exposed.

    On a completely different note:

    "A shortage of safe assets may be a problem for fiscal policy - as asset swaps by the central bank will not change the net supply of safe assets. Further, central bank lending policies may depend on the particulars of the crisis."

    This seems similar to Neo-chartalists assessments of monetary policy. What differences would you point to?

    1. 1. I think the history is more supportive of the view that some large financial event causes the runs. As you point out, in the recent financial crisis, you can trace events to the source, and it's not repo runs. Another example is the 1907 panic, which can be traced to the failure of a large financial institution in New York.

      2. I had to look up "neo chartalism" to find out what it is. To the extent that neo-chartalists have ideas about how monetary and fiscal policy are intertwined, I guess it's related. I have no idea whether neo-chartalism makes sense or not. In any case, in modern macro there are plenty of people who have worried about fiscal/monetary issues. e.g. Sargent and Wallace in the 1980s, and the people who worried about the fiscal theory of the price level (Woodford, Sims, Cochrane).

    2. "As you point out, in the recent financial crisis, you can trace events to the source, and it's not repo runs."

      I am afraid that Bear Stearns and Lehman are obvious cases of repo runs.

      "Notwithstanding that Bear Stearns continued to have high quality collateral to provide as security for borrowings, market counterparties became less willing to enter into repo arrangements with Bear Stearns," said Christopher Cox, SEC chairman

    3. No, go back further. It's not the repo runs. Those are symptoms.

    4. Can I ask what is the cause you are thinking?

      It seems that the "scarce of safe collateral" argument doesn't hold for the Bear Stearns case

  4. Steve: You write, "Canada and the U.S. are similar in many ways, but it is difficult or impossible to find anything that Reinhart-Rogoff or Bordo-Haubrich would call a financial crisis, in all of Canadian history." Actually, in Table A.4.1 (pp. 355-356) of their book, R&R list a considerable number of banking crises for Canada, the most recent for 1983-1985 (discussed in a 2001 paper by Bordo, Eichengreen, and two others); banking crises, along with beauty, are in the eyes of the beholders. So, in addition to the current spat between R&R and the Bordo-Haubrich-Taylor teams, can we say that you disagree with both groups (wrt Canada)?

  5. Now I can see what Reinhart and Rogoff are complaining about. There's an account of this episode here:

    The episode is notable, because there were two bank failures in 1985 - the Canadian Commercial Bank and the Northland Bank. These are two of the three chartered bank failures in Canada in the 20th century. The one other was in the 1920s. The 1985 failures involved two small regional banks and less than 1% of total bank assets in Canada. Small potatoes, and of essentially no macroeconomic significance.

  6. This was a fine post.
    The recent financial crisis involved a shortage of safe assets, more broadly.

    Actually, there were plenty of AAA (safe!) MBS paper up thru 2006. Then the rising house price bubble stopped, so housebuyer speculator flippers stopped bidding up, and were more just unloading houses in market whose prices were too high for non-speculator buyers.

    And then the AAA paper was downgraded.

    The biggest missing link in the econ blogosphere is tracking the ratings, and prices, of the AAA paper.

    Not a shortage of safe assets, a "run" on the value of assumed-safe AAA assets which quickly reduced their value. Because they were less valuable, it can be said in hindsight that they were not "safe", but they invested in as if they were safe.

    Such investment/ speculation in AAA paper that was to be derated was over-investment. Just like the builders had over-invested in more housing.

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