A Narrowing Gyre

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When the Journal of Economic Literature appears next month, it will contain two review essays surveying broadly the literature that has appeared so far on the financial crisis and its aftermath. For anyone who doesn’t want to wait, both articles are available now as working papers at Social Science Research Network. Non-economists will once again be reminded of the astonishing publishing service that SSRN performs as the top-ranked open-source repository in the world.

Since two of the authors, Gary Gorton, of Yale University, and Andrew Lo, of the Massachusetts Institute of Technology, are the economists who, over time, are most likely to be thought of as having gotten to the bottom of what happened in 2007-08 – they are, after all, the ones whom the editor, Janet Currie, of Princeton University, chose for  the task – the differences between their approaches are especially interesting.

Gorton, one of many investigators of the crisis, was from the beginning possessor of a better angle of vision than the rest, a bird’s-eye view. In their review, he and co-author Andrew Metrick, also of Yale, Lo, boil down the technical literature to a handful of path-breaking papers. Lo, who is co-editor (with MIT’s Robert Merton) of the Annual Review of Financial Economics, reviews only books. He is the controlling presence here, the referee, or, if you like, the regulator. Gorton and Lo are falcon and falconer, performing a joint task from different vantage points.

Reading about the Financial Crisis: A 21-Book Review  by Lo, divides its list in half: eleven books written by academics, and ten others, nine of them by journalists and one by former Treasury Secretary Henry Paulson.

At around 12,000 words, Lo’s review reads like an article in a high-tone magazine.  To describe his stance, he invokes Rashomon the famous 1950 film by Akira Kurosawa in which four conflicting accounts of the same murder are given, one of them twice.  The crisis was far more complicated than the movie, Lo says; like World War II, no single account can hope to encompass it all.  Even its starting date has yet to be agreed upon.  “Only by collecting a diverse and often mutually contradictory set of narratives can we eventually develop a more complete understanding…,” he writes.

(To illustrate his method, Lo at one point demolishes a contention that has been accepted as fact in many newspaper accounts – that a rule change by the SEC in 2004 led to great increases in firms’ leverage in the years before the crisis. “Without the immutable hard platform of objective facts on which we can build an accurate narrative of the crisis that stands the test of time, there’s little hope for scientific progress as the waves of public opinion toss our perspective in one direction or the other.”)

In contrast, in Getting Up to Speed: A One-Weekend Reader’s Guide, Gorton and Andrew Metrick, both of Yale University, zero in on sixteen technical documents, key papers from important journals and after-action reports from various regulatory agencies, with a view to sharply narrowing the issue. Their account is much more technical than Lo’s essay, as befits two researchers still deeply involved in the chase.  Every paper in their selection emphasizes measurement: “[W]e hope that this collection at least can answer the ‘What happened?’ question about the crisis, even if the ‘why?’ is not yet settled.”  They provide a useful timeline of the crisis and its aftermath as well.

(In The Big Short Shrift, a book review that appeared in an earlier edition of the JEL, Gorton also reviewed two of the best books by journalists about the panic:  The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History, by Gregory Zuckerman, and The Big Short: Inside the Doomsday Machine, by Michael Lewis. Zuckerman and Lewis, he wrote, had lucidly described the discovery of the mechanism  by which the big money was made (credit default swaps as an inexpensive way to bet that bond prices would fall), but the authors all but gave up on the question of why the crisis took the form it did. Gorton added, “My perspective on this – and all else here – is no doubt colored by my experience at AIG Financial Products, where I was a consultant for twelve years starting in 1996.”)

These review essays are intermediate goods, of interest mainly if you have already invested heavily in reading about the crisis.  My purpose here is mainly to alert readers to this ongoing process of evaluation and review, and afford a glimpse of the manner in which opinions are formed in several very different realms of discourse. Many Economic Principals readers will do well to simply look forward to the second round of books – including those by the authors of the reviews.

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Lo begins his review with six pages on the opposition between the first two accounts of the crisis to appear. Yale’s Robert Shiller completed The Subprime Solution: How Today’s Global Financial Crisis Happened and What to Do about It in April 2008 and published in August. It established the view that the crisis was mainly about the unraveling of a bubble in housing prices, and that the problem lay in the originate- to-distribute lending practices known as “securitization.” Among the many remedies Shiller suggested was a blueprint for the now-familiar Consumer Finance Protection Bureau.  Greater transparency, better databases and more supervision would provide some degree of bubble protection, he ventured – a view he subsequently elaborated, with George Akerlof, in Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism.

About the same time as Shiller’s book was published, the crisis was entering a new phase, Lo writes, and a paper presented at almost the same moment by Gorton in August 2008 at the annual Jackson Hole Conference of the Federal Reserve Bank of Kansas City provided a much more detailed description of its mechanics. “The Panic of 2007,” subsequently published in 2010 with two other essays as Slapped by the Invisible Hand, “quickly became a hot topic of discussion among economists, policymakers and – something new under the sun – as samizdat for interested laypeople on the Internet,” Lo writes.  Gorton’s account included a guide to several areas of specialized financial engineering that were about to take a central role in the panic of 2008.

“What Gorton describes is a machine dedicated to reducing transparency,” Lo writes. In a few deft paragraphs, striking for their compression, he describes two alternative hypotheses that have developed about the fundamental reason for the crisis:  the originate-to-distribute view, which holds that the basic problem was securitization itself, with less greed and more transparency as the answer; and the asymmetric- information view, which emphasizes the role of securitized- debt instruments as “safe assets,” deemed comparable to US Treasury debt and used similarly to support a wide variety of transactions in the global economy, but vulnerable at certain times to attacks on their opacity by information-hungry investors – an arrangement comparable in many ways to the confidence that we repose in retail banks. “Perhaps with the benefit of more hindsight and data collection, we can get to the bottom of this debate in the near future,” Lo writes.

The basic issue framed, Lo then quickly runs through the rest of his choices, in the order of their appearance.  On the analogy of a big war, he says, economists have been the strategists, diplomats and gadflies of the crisis, while journalists were the war correspondents, documenting “the campaigns, battles and the exceptional acts of courage and cowardice among individuals and battalions.”

Among the economists’ interpretations he appraises are This Time Is Different: Eight Centuries of Financial Folly, by Carmen Reinhart and Kenneth Rogoff; The Great Crash of 2008, by Ross Garnaut, an economist, and David Llewlyn-Smith, a journalist (something of a sleeper, since it was originally written for an Australian audience); Freefall: America, Free Markets, and the Sinking of the World Economy, by Joseph Stiglitz; Thirteen Bankers: The Wall Street Takeover and the Next Financial Crisis, by Simon Johnson and James Kwak; Crisis Economics: A Crash Course in the Future of Finance, by Nouriel Roubini and Stephen Mihm; Fault Lines: How Hidden Fractures Still Threaten the World Economy, by Rahhuram Rajan; The Squam Lake Report: Fixing the Financial System, a bipartisan group that met in New Hampshire during the autumn of 2008; and Guaranteed to Fail: Fannie Mae, Freddie Mac, and the Debacle of Mortgage Finance, by Viral Acharya, Matthew Richardson, Stijn van Nieuwerburgh and Lawrence White

Among the journalists’ accounts are House of Cards: A Tale of Hubris and Wretched Excess on Wall Street, by William Cohan; Fool’s Gold: The Inside Story of J.P. Morgan and How Wall Street Greed Corrupted Its Bold Dream and Created a Financial Catastrophe, by Gillian Tett; Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System – and Themselves, by Andrew Ross Sorkin; The Greatest Trade Ever, by Zuckerman; The Big Short, by Lewis; The End of Wall Street, by Roger Lowenstein; The Clash of Titans: Greed, Hubris and the Fall of Merrill Lynch, and the Near Collapse of Bank of America, by Greg Farrell; All the Devils Are Here: The Hidden History of the Financial Crisis, by Bethany McLean and Joseph Nocera; and Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon, by Gretchen Morgenson and Joshua Rosner. On the Brink: Inside the Race to Stop the Collapse of the Global Financial System, by former Treasury Secretary Paulson, rounds out the list.

Lo concludes his review with what is, by now, his familiar plea for the creation of a financial investigative body closely modeled on the National Transportation Safety Board, the organization that investigates not just airplane crashes but other transit disasters, too, in their immediate aftermath. He and a pair of coauthors have described their proposal in The National Transportation Safety Board: A Model for Systemic Risk Management. Their case is compelling.

But just as an NTSB investigation of a particular event would have been of little use in understanding World War II (though rough approximations of its methods probably were employed by all sides in various emergencies throughout its duration), so an authoritative report on a single financial failure is unlikely to explain the crisis. The real usefulness of such a body, if it is ever to be established, lies in the future, when its expert investigators could quickly descend on an unexpected and puzzling collapse – like the moment in June 2007 when a pair of Bear Stearns hedge funds tanked, sending out the first faint tremor of what eventually would become a massive earthquake. Prospective alacrity is a highly desirable thing, in the future. To make sense today of the most recent crisis, what we need are theorists and historians.

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Lo envisages one set of methods in his review. In theirs, Gorton and Metrick envisage another.  All economists should be at least conversant with what happened during the crisis, they say. (Good luck with that!)  They assembled their list for those who want to “get up to speed on the crisis, without having to go into a cave and read for a year.” Hence its brevity, many interesting papers omitted, just sixteen key documents in all, grouped under six headings:  an overview (and timeline); historical background; the crisis buildup; the two phases of the panic (August 2007 and September 2008); government responses; and the effects of the panic on the real economy.  There is no discussion of the ongoing Euro-currency and sovereign debt crises.

Just how gradual was the learning curve before the crisis is apparent from the short list of important papers that anticipated one or another aspect of what happened.  Gorton and Metrick recommend only three papers from the run-up: in 2003, Karl Case and Robert Shiller (“Is There a Bubble in the Housing Market?”); in 2005, Ben Bernanke (“The Global Savings Glut and the US Current Account Deficit”); and in early 2008, Reinhart and Rogoff (“Is the 2007 US Subprime Financial Crisis So Different? An International Comparison”).

Even in 2009, there were only emergency reports:  the Bank for International Settlements (79th Annual Report); and the International Monetary Fund (“Navigating the Financial Challenges Ahead”).

Then, starting in 2010, came something like a dawn:  the International Monetary Fund (“Global Financial Stability Report: Sovereigns, Funding and Systemic Liquidity”); Victoria Ivashina and David Scharfstein (“Bank Lending During the Financial Crisis of 2008”); Murillo Campello, John Graham, and Harvey Campbell (“The Real  Effects of Financial Constraints: Evidence from a Financial Crisis”); Patrick McCabe (“The Cross Section of Money Market Fund Risks and Financial Crises”); and Bernanke (“Statement before the Financial Crisis Inquiry Commission”).

In 2011, Daniel Covitz, Nellie Liang, and Gustavo Suarez (“The Evolution of a Financial Crisis: Panic in the Asset-Backed Commercial Paper Market”); Zoltan Pozsar (“Institutional Cash Pools and the Triffen Dilemma of the US Banking System”); Reinhart and Rogoff (“From Financial Crash to Debt Crisis”).

And in 2012, Gorton and Metrick (“Securitized Banking and the Run on Repo”);  Manju Puri, Jörg Rocholl, and Sascha Steffan (“Global Retail Lending in the Aftermath of theUSFinancial Crisis: Distinguishing Between Supply and Demand Effects”); and Moritz Schularick and Alan Taylor (“Credit Booms Gone Bust: Monetary Policy, Leverage Cycles and Financial Crises, 1870-2008”).

Tough sledding, but this is what economists are writing for one another.  A good thing, therefore, that Gorton’s book, Misunderstanding Financial Crises: Why We Didn’t See One Coming, will appear later this spring, once again in the first of a batch, in this case, of reappraisals.

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Falcon and falconer.  These images don’t map with any great precision onto the task of scientific and, in this case, forensic investigation, but they convey well enough the relationship between a leading edge and a consensual center.  I borrowed the metaphor, obviously, from The Second Coming, William Butler Yeats’ great [editor: dead from overuse!] poem, with its famous lines,

Turning and turning in the widening gyre
The falcon cannot hear the falconer;
Things fall apart; the center cannot hold;
Mere anarchy is loosed upon the world,
The blood-dimmed tide is loosed, and everywhere
The ceremony of innocence is drowned;
The best lack all conviction, while the worst
Are full of passionate intensity.

Yeats wrote that in 1919, far tougher times than these, after the First World War, the Russian Revolution and the failed Easter Rebellion in Dublin.  (An early draft, adverting to the years in Great Britain after the French Revolution, included the line, “And there’s no Burke to cry aloud, no Pitt.”)  Yeats’ second stanza anticipates that in the twentieth century there will be still worse to come:  “What rough beast, its hour come round at last,/Slouches towards Bethlehem to be born?”

In the present case, I think, the situation is reversed. Passionate intensity among commentators is subsiding. Cooler analysis is coming to the fore.  A better theoretical understanding, if not a revelation, is in the offing. Gorton and Lo and all the rest of the community of economics are not a bad substitute for Burke and Pitt (though it would be nice to think that we could have their equivalents, too).

Nearly five years after it began, the financial crisis of 2007-08 is coming to be understood, in ways that it was not at first.  This gyre is narrowing.