Arnold Kling  

So Many Narratives

Some Intellectual History for ... An Unanswered Question on the ...

Eric Falkenstein summarizes many books on the financial crisis, concluding

For me, the best explanation comes from two parts. Stan Liebowitz's account on how we slowly eroded mortgage standards with the best intentions, led by academia, regulators, legislators, and investment banks. And then the accelerator mechanism outlined by Gary Gorton. Neither are books.

I agree that it is useful to think of what happened in the housing market and what happened among financial institutions. However, I think that Gorton's "modern bank run" theory makes it seem as though the banks were fundamentally sound--just caught short of liquidity. I suspect that view is a bit self-serving on Gorton's part (he helped get AIG into credit default swaps).

In the housing market, the positive feedback loop between increasing house prices and lower lending standards seems pretty important. It would be interesting to know whether other countries with housing bubbles also saw lower lending standards.

With financial institutions, I stress the use of regulatory capital arbitrage that allowed financial institutions to load up on risk. I think that their losses genuinely exceeded their capital. It was not just a liquidity panic.

Of course, the popular narrative is that it was greed coupled with the ideology of deregulation. My view is that regulators aided and abetted the crisis. They winked at lower lending standards because of the political popularity of broadening home ownership. They winked at regulatory capital arbitrage because they could not envision anything going terribly wrong.

COMMENTS (1 to date)
TA writes:

Falkenstein's rendition of Gorton is incoherent in places.

As to Gorton, clearly there was a run by repo lenders, but if you pore through the Fed's funds flow reports, it isn't obvious that it was all that big a problem in the larger scheme of things. Commercial banks don't fund themselves through repos all that much. Broker dealers do, but seem to have responded by squeezing down securities borrowing and associated need for cash collateral. Maybe it was a problem for Merrill, Bear and Lehman, but I'm still skeptical that their problems were such a disaster for the system as a whole.

The problem I have with Gorton's paper -- he has kind of a structural argument, but doesn't tie it to funds flow volumes, balance sheets, etc., so you really can't tell what it amounts to.

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