Interview with Gary Gorton

From FTAlphaville's email interview with Gary Gorton a year ago.

[In a sentence: Bank runs are when there is a surge in demand for short term bank debt, following herds, etc.]

The concept of money, and specifically how short-term bank debt acts as money, plays a big role in your book. What does it mean for this money to “trade at par”, and why does it matter for the stability of the banking system?

It is easiest to think of the case where the money does not trade at par. An example of this situation is the American Free Banking Era prior to Civil War. At that time, each bank issued its own money backed by loans or state bonds. When used in transaction at some distance from the issuing bank, the money traded at a discount. My ten dollar bill, issued by a bank in New Haven,Connecticut would only be worth maybe $9.50 in New York City. But, no one knew for sure what the discount really should be and we would have to argue over this. Transacting in this way is difficult. So, creating private money with the feature that a ten dollar bill—or a check for ten dollars—would always be accepted as worth ten dollars would make money more efficient. This would require backing that was more credible.

But, even if society can get to the point where the money is accepted at face value, there is still the danger that people or firms lose confidence—they come to question the backing assets and ask for their cash. Privately-produced money is inherently vulnerable in this way.

Relatedly, you write: “There is almost no evidence that links capital to bank failures.” But you don’t write that capital requirements are a waste of time, only that they won’t prevent crises.

Capital requirements were never the sole focus of attention for bank regulation until the 1980s. Again, there is a basic misunderstanding of financial crises. A bank run is a demand that all short-term debt in the banking system be turned into cash. That is simply not possible. It would be best to create a system where such a demand does not arise because the government’s oversight has created sufficient confidence. Capital per se cannot do this.

Okay, but you can’t be saying that “bad greedy bankers” played *no* role in the crisis, right? That issues like mortgage fraud, lax underwriting, misrepresentations by mortgage lenders to the GSEs, things like the Magnetar and Abacus cases and other items that we’re still picking through should be minimised?

If greedy bankers cause crises, we would have a crisis every week. The Quiet Period from 1934 (when deposit insurance was adopted in the US) until 2007, during which there were no systemic crises, is not explained as being due to non-greedy bankers. What, then, caused bankers to suddenly become greedy? In every crisis in history, it happens that fraud is uncovered. Partly this is due to the fact that everyone asks for their money, and sometimes it cannot be produced (as with Madoff). Other times it is the heightened scrutiny of the financial system that reveals these problems.

I am not saying that these problems are unimportant. But I am saying that an explanation of the recurrence of systemic financial crises throughout the history of market economies cannot be explained by greed or fraud, etc. These are not explanations of crises and they are not the central problem. We are talking about systemic crises: that is crises in which the entire financial system is at risk. In Bernanke’s testimony before the U.S. Financial Crisis Inquiry Commission, he said that 12 of the 13 largest financial firms in the US were about to fail. How exactly does greed cause that, but it did not during the Quiet Period?

But you also write, for instance, that historically many bank runs have started after credit-driven land price and real estate booms. It seems like mandating more prudential lending standards would help — if not prevent future bank runs, then make them less frequent or less severe.

I don’t think that will help. It is an inherent feature of private economies that they cannot create riskless debt. What is the proposed lending standard, that banks are only allowed to make riskless loans? The fact is that the economy needs and wants private bank money—short-term bank debt. Such debt cannot be completely riskless. That is the problem that needs to be addressed by the government.