Interview: Gary Gorton on financial crisis

You claim that systemic financial crises all share a common structural cause: they begin as runs on short-term bank debt. Do you observe any forthcoming crisis recently? The recent financial crisis of 2007-2008 was a run on short-term bank debt.  In that case, the short-term debt was sale and repurchase agreements (repo), asset-backed commerical paper, and money market funds.  These forms of money were backed by privately-produced asset-backed securities, the value of which became suspect at the start of the crisis.  In the 147 systemic financial crisies since 1970, identified by the World Bank, over 60 percent had bank runs.  The others did not have runs because the government issued a blanket guarantee of the deposits or nationalixed the banks.

Why are banks first-to-save in crises? Do you think that bail-out of banks worked to solve latest financial crisis? The banking system is essential to the functioning of a market economy.  A financial crisis is an event in which the solvency of the entire system is threatened.  In every financial crisis in history, the society of every country has found a way to keep the banking system from being liquidated. While this may not be popular, it is clearly better than the alternative.  In the recent crisis, the U.S. Federal Reserve adopted a number of very creative lending programs to save the banking system.  Overall this worked very well.

 You also write that the collateral backing short-term bank debt must be “secretless” and information-insensitive. EU struggle to regulate banking system. Do you think that the new regulations can overcome this problem? The idea of money is that it should be accepted by the counterparty without suspicion as to its value.  A ten dollar bill should be accepted as ten dollars without doing due diligence on it.  This is also true of the forms of money that banks, institutional investors, corporations, sovereign wealth funds, and other large entities use.  That money needs to be backed by assets that are also accepted without suspicion.  This is what “information-insensitive” means.  It means that the value of the money does not fluctuate.  In the current crisis, the European Central Bank lent enormous sums, backed by collateral that has become sensitive to information.  Regulation is not enough.  The specifics of how this is done are very important.

What do you think about Tobin tax? Can it be significant solution for future crises?The Tobin tax has nothing to do with financial crises and will not solve the problem.

Turkish PM has a famous saying in Turkey for 2008 financial crisis: “The crisis passed at a tangent to Turkey” Do you think that the global crisis had different effect for different countries? Of course there were different effects for different countries.  But all market economies are vulnerable to crisis if short-term bank debt is not detected and protected.

You claim that the actions of government can prevent bank runs but seems to increase the costs of crisis resolution if there is a crisis. What do you advice to the government to save economy against the crises? Typically the government is unaware of the build-up of fragility prior to a crisis and has not taken steps to protect short-term bank debt.  Market economies are constantly evolving and new forms of banking and money are invented.  Governments must understand this and detect it.  Then steps need to be taken to protect it from runs.

You state a two-part solution for regulators: the creation of “narrow funding banks”, and regulating repo. Would you give me details about this claim? The basic idea is for the government to regulate the creation of private assets that are used for collateral, in particular asset-backed securities.  The securities, under the proposal, would have to be sold to competitive narrow funding banks.  These banks would do nothing other than buy these securities and issue liabilities, which would be long or short.  They would not take deposits, or engage in proprietary trading, etc.  They would be regulated, have capital requirements, and would have access to the discount window of the central bank.  The idea is to be constructive about this very large market (the asset-backed securities market) to recreate confidence in it.

Turkish government is proud of strong banking regulation and system. Is only strong banking system enough to survive in crisis era? No.  Market economies evolve so “strong” regulation at one point in time is not sufficient as the system evolves.

Some economists are pessimictic about 2013-2014. How do you predict 2013 and 2014? The U.S. and Europe are likley to experience weak growth and relatively high unemployment through 2014.  Few steps have been taken to alleviate the problem.  Governments seem to have run out of ideas other than to just wait.

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