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The Financial Crisis' Missing Link

Posted by Josh Rothman  January 3, 2011 01:00 PM

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At this point the general outlines of the financial crisis have become clear: banks invested in what they knew was a mortgage bubble, and got their clients to invest in it, too; then the bubble burst. The question is: how exactly did that bubble-bursting slow down the whole global economy? How did a simple mortgage crisis transmogrify into a global financial crisis?

Yale financial economist Gary Gorton explains the process in this spectacular (though technical) interview with The Federal Reserve Bank of Minneapolis. The answer comes down to the nature of money itself. Money, Gorton says, is always vulnerable to panic once people start to look at how it's made.


Gary Gorton, a finance economist at Yale.

To understand today's crisis, Gorton believes that you need some historical perspective on the financial system. He starts by looking back more than 150 years, to America before the Civil War.

Back then, every bank printed its own currency - and the result was that currency diminished in value as it traveled. If you took a $10 bill from the Bank of New Haven and then traveled to New York, you could expect your bill to be worth less than $10 when you arrived. Why? Because a New Yorker couldn't be sure that the Bank of New Haven hadn't gone bust. You could use that bill to buy groceries, say, in New York, but only after the the grocer had charged a "discount" of about fifty cents. At the cash register, Gorton says, "the cashier is looking up in this little newspaper to figure out what the discount is."


Would you trust this dollar bill?

All this uncertainty about the value of a dollar was slowing down the economy - so in 1863, the National Bank Act created America's first national currency, guaranteed by the Federal Government. The key change, Gorton says, was that dollar bills went from being "information sensitive" to "information insensitive": Once you didn't have to worry about the value of a dollar, you could spend and accept dollars more freely. But, he notes, this improvement in the financial system necessarily involved the creation of a "shadow banking system." There was now a bank behind your bank, doing all sorts of mysterious things.


America's first national currency.

Over the next half-century, Americans got richer: instead of hiding cash under their beds, they started opening checking accounts. But the same logic that applied to bank-issued currency also applied to checks. "In the late 19th century," Gorton explains, "academics were literally writing articles with titles like 'Are Checks Money?' in top economics journals." A check, after all, is just a kind of money printed by a bank: You give a bank your dollars, and they give you a checkbook. How do you know that the bank on which these checks are written has enough money to cash them?

Until the Federal Deposit Insurance Corporation was established in 1933, insuring all checking accounts up to $250,000, checks and checking accounts remained "information sensitive," and prone to panic. Another layer of "shadow banking" had to be put in place, so that people could start writing and accepting checks without worrying about it.


A modern trading floor.

Fast-forward to today, and Americans, along with others all over the world, have moved way beyond checking accounts. We now keep our money in stocks, mutual funds, and pensions - and so huge amounts of money are now held by so-called institutional investors. These institutions, Gorton explains, also need "checking accounts" - a place to put $200 million for the night. Unfortunately there aren't any FDIC-insured checking accounts that big. The solution is something called a "repurchase agreement, or "repo." Your mutual fund gives a big bank (like Lehman Brothers) $200 million at the end of the day, and Lehman gives your mutual fund a bond promising to pay it back in the morning. Since no one is backing that bond other than the bank, the bank has to provide collateral. What does it used for collateral? Something really stable and trustworthy - like AAA-rated mortgage-backed securities!

That, according to Gorton, is how a crisis in American home prices led to a worldwide financial meltdown. Big investors started to doubt that those bonds were good - in Gorton's terms, their checking accounts became "information sensitive" - and, just like antebellum New York City grocers, they demanded a discount. How much? Of about 30%, or $3 trillion globally. Banks had to raise that cash somewhere, so they started selling off collateral... and the rest is history.

How can we fix the system? Start, Gorton says, by recognizing that "shadow banking" is important and irreplaceable - then regulate it. Gorton proposes setting up a group of government-backed banks chartered specifically to offer "checking accounts" to big institutions. The goal, he says, is to make money information-insensitive again - to delegate the complexity of corporate banking in the same way that we delegate the complexity of individual banking. Think, he says, of the electrical grid:

[O]nce the electricity grid fails... and you have a blackout, the answer is not that we want everybody to become an electrician. We don’t want to post complicated diagrams of electrical circuitry on the Web for everyone to study. The answer is to create - to re-create - a world where nobody needs to know about electricity.... In the crisis, when investors really started to think about how subprime securitization works, it turns out to be extremely complicated, even compared to a standard securitization. You don’t want to have to study that. Not everybody needs to know that.

Gorton's whole, wide-ranging discussion is worth reading. The upshot: money works best when you never have to think about it. That's as true for mutual fund managers as it is for you and me.

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About brainiac Brainiac is the daily blog of the Globe's Sunday Ideas section, covering news and delights from the worlds of art, science, literature, history, design, and more. You can follow us on Twitter @GlobeIdeas.
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Joshua Rothman is a graduate student and Teaching Fellow in the Harvard English department, and an Instructor in Public Policy at the Harvard Kennedy School of Government. He teaches novels and political writing.

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