David R. Henderson  

Selgin on Gorton

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One of the best writers in economics, and one of the very best thinkers in monetary economics, is University of Georgia economist George Selgin. I highly recommend his recent critical review of Gary Gorton's recent book, Misunderstanding Financial Crises.

After praising Gorton for understanding the importance of economic history in analyzing today's issues, Selgin criticizes Gorton for not applying his own lesson. As Selgin puts it:

Gorton's recommendations are consistent enough with his understanding of financial developments leading to the 2007-8 crisis. However, that understanding warrants a judgement similar to the one Gorton himself offers regarding less history-conscious attempts to explain that episode, to wit, that it is a "superficial" understanding suggesting "a lack of institutional and historical knowledge" (88-9). The difference is that Gorton has the knowledge in question, as is apparent from his other writings and also from the works, with which he's evidently familiar, discussed in his "Bibiographical Notes." Nevertheless his book fails to make proper use of that knowledge.

How so? Selgin continues:
Gorton is wrong, first of all, in claiming that financial crises are "inherent" and "pervasive" in market economies. He errs both by not allowing that different "market" economies have had very different kinds and degrees of financial regulation, and by not consistently heeding his own definition of a banking "crisis" as a "systemic" (or at least "widespread") "exit from bank debt," that is, a situation involving "en masse demands by holders of bank debt for cash" (pp. 6-7, my emphasis). According to this definition many of the "crises" listed on Gorton's Table 3.1 were not genuine financial crises at all. Canada, to take one example, did not have a genuine financial crisis in any of the years listed (1873, 1906, 1923, and 1983), though it did have to relax binding capital-based note issue regulations to avoid having a crisis in 1906.

Why does Selgin single out Canada? Here's why:
I refer to Canada in particular because, with regard to Gorton's thesis, it is, not the only, but certainly the biggest, elephant in the room. Its record is especially revealing, because the Canadian economy of the 19th and early 20th centuries resembled the U.S. economy in many ways, though it differed in its banking structure and regulations. Unlike U.S. banks, Canadian banks could and did establish nationwide branch networks; they were also allowed to issue notes backed by their assets in general rather than by any specific collateral. It was, finally, no coincidence that the extra degrees of banking freedom that Canada enjoyed were associated with a much better record of financial stability. To put the matter differently, Canada's record suggests that the shortcomings of the U.S. banking system where not shortcomings "inherent" to all private banking and currency systems. They were shortcomings traceable to specific, misguided U.S. banking and currency laws.

I had to move from Canada to the United States before finding out that Canada did not even have a central bank before 1935. My father was born in 1910. Which means he was an adult when Canada got a central bank.

And how did it work out? Well. Selgin writes:

But by the 1890s Canada, despite being far less populous than the U.S., while occupying more square miles, had a uniform currency consisting mainly of private Canadian banknotes that were not subject to any special "backing" requirement. How could that be? That Canada's banking system was a "club oligopoly" may have helped. But there's another explanation, which also accounts better for other instances, such as Scotland's, of uniform currencies consisting of private banknotes backed by bank-specific assets. This is that Canadian banks, unlike their U.S. counterparts, were free to establish branch networks, and that such networks, together with note clearinghouses established in major trade centers, sufficed to eliminate note discounts, by reducing to trivial amounts the cost to banks of presenting rival banks' notes for payment.

Gorton is well known for having devised models for AIG. But Selgin doesn't take a cheap shot at him for that. Instead, he takes a quality shot, with this ending:
Unsurprisingly, the lesson taught by this different understanding of financial history itself differs dramatically from the one Gorton offers. It is that there are better ways to avoid financial crises than by trying to regulate risky bank debt out of existence. They are better both because they can actually succeed (whereas the war on debt Gorton proposes would probably prove as futile as the war on drugs) and because they get rid of the financial crisis bathwater without sacrificing the financial intermediation baby. For that reason I'm convinced that, should Gorton's version of history prove persuasive, it could end up proving no less misleading, and far more costly to society, than the models he concocted for AIG.

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CATEGORIES: Monetary Policy , Money

COMMENTS (8 to date)
Grieve Chelwa writes:

You are right David about Selgin being one of the best writers in economics. I always, always, look forward to his blog posts. His speeches are no less entertaining and no less educative. He recently gave a talk to the Adam Smith Institute in London (available on Youtube) where he was just as entertaining.

David R. Henderson writes:

@Grieve Chelwa,
Yes. Plus I learned a new expression: "sua culpa."

Mark V Anderson writes:

This posting seems to be more about the benefits of following Canada's lead in banking than it is a critique of Gorton.

I think I heard this previously, that Canada hasn't suffered as much as the U.S. in the Great Recession, largely because of a superior banking system. So if this is true, has Selgin or someone else done a complete (maybe book length?) analysis of the history of Canadian banking, with its ups and downs, as well as how the U.S. would have to change to match the Canadian experience? I'm certainly not convinced at this point that the Canadian system is the way to go, but all other plans I've seen are severely flawed, so it would be worthwhile to see a plan that actually has a history of success behind it.

eric falkenstein writes:

I too admire Gorton and find his prescriptions lame. Gorton makes a good point about shadow finance with repos, and how many of these were backed by CDOs, which after 2007 were less than perfectly safe. This certainly didn't help. But I'm not sure this mechanism, repos, was the necessary or sufficient cause of the 2008 crisis, and regulating away risk tends to just make it less obvious (eg, you can ban leverage, but then, own things that are levered, so the leverage is just pushed downstream).

Finch writes:

All is not sunshine and buttercups in Canadian banking. Notably, it seems more expensive and less innovative. Canada is notable for having the most expensive mutual funds in the world. They may have missed the last crisis because they were slow taking up new mortgage technology, which was a happy accident rather than a grand plan.

It's like US banking, but with less competition. Usually that's bad.

George Selgin writes:

Finch's attempt to suggests that Canada's banking system isn't any better than the U.S. system fails on several grounds. First, and obviously, the systems aren't "like" one another in all sorts of non-trivial ways, and were even more radically unalike in the past than they are now. Second, there isn't much evidence supporting the claim that the Canadian banking market is uncompetitive. (Concerning its mutual funds, I cannot speak.) Finally, the suggestion that Canada avoided a banking crisis in 2008 only because it was lucky begs the question: how did it also manage to avoid most previous North American banking crises?

No one claims that Canada's arrangements are ideal. But it is ludicrous to claim that they are (or have been), not only "bad," but worse than U.S. arrangements.

Finch writes:


"From Table 5 we can see that , after controlling for fund type, fund size, complex size and other variables, the U.S. is among the lowest cost countries (by fund registration) in our sample, and Canada is the single highest fee country by far."

Mutual funds are just an obvious example that I happened to have a quick cite for, but my experience is that Canadian banking is like this in general. It's a conservative oligopoly. So it doesn't get burned when newfangled stuff goes bad, but it costs a fortune and provides poor service.

Fergus O'Rourke writes:

@Finch & George Selgin

I am more with Selgin here.

It does seem to be the case that Canadian banking is more costly and less dynamic generally. But this is what one would expect with a safer or more "anti-fragile" system.

It's essentially inevitable: there is a trade-off between dynamism, including robust competition, and safety. Of course, we will always be seeking the "sweet-spot" where both are optimised. However, the notion that there is a painless path - which is my (amazed) take from the Admati & Hellwig book - is a pipe-dream.

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