How Financial Crises Start

A number of people saw the problems that culminated in the financial crisis of 2008. They saw the problems clearly and early and predicted that bad things had to happen. Most of these people were way too early. See the book The Big Short by Michael Lewis for details. They predicted a calamity, but things kept humming along, they thought inexplicably. Even today, there are many people predicting problems from debt in Europe, bubbles in China, and unresolved problems in the U.S. Yet, stocks keep rising.

Gary Gorton is an economist who’s published on the issue of what causes or starts a financial crisis. His thesis is that while the conditions for a financial crisis are things such as excess debt, but they don’t cause or trigger the crisis. Gorton says a crisis is triggered by a bank run or runs. In 2008, we had sort of an invisible bank run, because it was a run on the shadow banking system of packaged loans that were traded electronically. He gives an interesting interview in FTAlphaville. It’s a little lengthy but worth your time.

Since 1970 there have been about 145 systemic banking crises around the world, and not just in developing economies. In about 65 percent of these cases there were bank runs. The problem is that market participants expect the government or the central bank to act, and so the run—if there is one—is delayed. This seems to result in larger crisis costs.

This problem of expectations of government actions changing the timing of crises is best solved by designing regulations that avoids a crisis to start with. There are examples of this in history—recent history—where economies have not experienced a crisis for a long period of time. That should be the goal of regulation.

Explain what you think is the relevance of the concepts of moral hazard and Too Big To Fail.

I think these words have really lost any meaning, and instead are bantered about as political slogans. Even before the Federal Reserve System existed banks bailed out other (big) banks during crises. Basically, these ideas attribute crises to the government, seeing government actions as the cause. The underlying problem of bank runs is not seen as the problem. Hence, Dodd-Frank has “living wills” so that it will be easy to liquidate the banking system. This confusion between the actual problem and the government’s response to the problem has largely become a political issue.