Saturday, August 1, 2015

On the Great Financial Panic of 2007

(a) I've always felt that the "Great Financial Panic of 2007" was a good old-fashioned banking panic, even if the modern version at first looks quite different from those of the nineteenth and early twentieth centuries. Gary Gorton's wonderful book, building on his earlier research, gets it exactly right:
"Holders of short-term liabilities...refused to fund "banks" [that is, various vehicles in the shadow banking system] due to rational fears of loss. ... As with the earlier panics, the problem at root is a lack of information."
(b) Simultaneously, I've always felt that the Great Panic of 2007 was largely driven by "too big to fail" (TBTF) (e.g. see Gary Stern here), which creates incentives that promote excessive risk-taking. (If you win, you make a fortune; if you lose, you get bailed out.)

What didn't occur to me until a dinner with Gorton during the 2015 PIER Workshop is that (a) and (b) are largely incompatible. That is, if the Panic of 2007 really is like those of the nineteenth century, then it can't have been driven by TBTF, which didn't exist back then. And the Panic of 2007 really was like those of the nineteenth century. 

So my view has evolved significantly: TBTF may well have made the Great Panic more likely than it otherwise would have been, and TBTF may well have increased its severity relative to what otherwise would have been, but TBTF simply can't be "responsible." Thanks, Gary for pushing me forward.