Banking in the Shadows
The Region: In Chairman Bernanke’s recent speech about what the financial crisis means for economics, he suggests that because standard macro models were designed to understand noncrisis periods, they don’t have much to say about crisis or financial instability.
I gather you would agree?
Gary Gorton: The way standard models deal with it is, I think, incorrect. A lot of macroeconomists think in terms of an amplification mechanism. So you imagine that a shock hits the economy. The question is: What magnifies that shock and makes it have a bigger effect than it would otherwise have? That way of thinking would suggest that we live in an economy where shocks hit regularly and they’re always amplified, but every once in a while, there’s a big enough shock … So, in this way of thinking, it’s the size of the shock that’s important. A “crisis” is a “big shock.”
I don’t think that’s what we observe in the world. We don’t see lots and lots of shocks being amplified. We see a few really big events in history: the recent crisis, the Great Depression, the panics of the 19th century. Those are more than a shock being amplified. There’s something else going on. I’d say it’s a regime switch—a dramatic change in the way the financial system is operating.
This notion of a kind of regime switch, which happens when you go from debt that is information-insensitive to information-sensitive is different conceptually than an amplification mechanism. So there’s a problem. Conceptually, the notion of adding things to existing models—a friction or an amplification mechanism—retains this overall paradigm in which financial intermediation generally has no role. I don’t think that is going to work.
Region: What are your students interested in, if not measurement?
Gorton: Most of my students are from the economics department at Yale, and a lot of those who come over to finance are interested in the crisis and behavioral finance. There’s always a core group interested in econometrics and game theory. But the big shift has been students interested in the crisis and behavioral economics generally. And I view that as fantastic. Hopefully, they’ll get somewhere on this stuff.
I think when we look back in 10 years, we might see the crisis as sort of a turning point in the [Robert] Lucas program [stemming from his rational expectations research]. The Lucas program was just earth-shattering. Unbelievably great. If you could give out Nobel prizes like Cy Young awards, Lucas would probably win one every year. It’s astounding when you think about the accomplishments of this guy.
But what is going to happen, I hope, is that we realize declining returns have set in there and we need to move in a different direction. I’m hoping the crisis jars my colleagues into this; I don’t know if it will.
I mean, one thing I’ve noticed is that most people who are about my age in the profession, basically, their response to the crisis was to say, “All the stuff I’ve been doing for the last 25 years is relevant, and here’s why. I can explain the crisis.” Which is wrong, and we know it’s wrong. Whereas students are coming to it with a fresh eye. I think it’s hard to have a fresh eye when you’ve spent years doing whatever you’ve specialized in.
Region: But if somebody invents a financial instrument and the economists or data geeks don’t know about it because it’s brand new, they’re not going to know they should measure it, true?
Gorton: In our proposal for measurement, we propose a big supplement to, essentially, the call report, but it’s for all financial firms, where we say, “We want to know the change in the value of your firm and your liquidity positions,” which we define in a certain way. If the following happens—housing prices go down by 2 percent, 5 percent, 10 percent, 15 percent, 20 percent and so on—how does your value change? And we ask you 200 questions. We also drafted a questionnaire. I won’t bore you with all the details, but it’s the sensitivity to different risks. So we don’t ask you about the actual financial instrument; but if that financial instrument causes your sensitivity to this risk to go up, and we see that that happens to every bank, then we know something.
It’s not perfect, but getting the measurement system into the 21st century is the logic of it. But, again, I would point out that the overriding issue here, I think we should understand, is the vulnerability of bank money to panic. That’s the issue. It’s not that other things are unimportant. But we haven’t had trouble with the other things in the sense of a global financial crisis.
If you had brokers cheating people, predatory lending, declines in underwriting standards, or you don’t like credit derivatives or something, whatever it is, those things per se are not a global financial crisis. And it’s the global financial crisis that is the first-order effect to be dealt with. And I think we know, we should know by now, what the problem is and what to do. My concern is that we’ll go another 77 years before we figure it out.