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September 5, 2010
David Warsh, Editor


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Now The Real Work Begins

So much for summer vacation.  It’s back to work for Economic Principals.  Doing what?  Plowing through the torrent of literature of the 2007-09 crash, among other things. The experts’ deciphering of the crisis is nearly complete. Now the real work begins.

The best account of what happened, packaged as a book and intended for the intelligent lay reader, still seems to me, as it did in April, that of Gary Gorton, of Yale University, Slapped by the Invisible Hand: The Panic of 2007, which described the problem as the high-tech equivalent of an old-fashion nineteenth-century banking panic.

Federal Reserve chairman Ben Bernanke shares my opinion, I was gratified to learn, first from Wall Street Journal reporter Michael Corkery on the WSJ’s Deal Journal blog, then from reporter Sewell Chan, writing Friday in The New York Times.

We can look forward to the report of the Financial Crisis Inquiry Commission, at whose hearings Bernanke was testifying last week. The FCIC’s investigation, undertaken in the spirit of various Congressional inquiries, including the Report of the 9/11 Commission and stretching all the way back to the 1932 Pecora Hearings (which led to the passage in 1933 of a long-lasting banking reform, the Glass-Steagall Act), is due to be submitted to Congress on December 15.

Its narrative, which to be written by former Time magazine columnist Matt Cooper, a staff member, will be published as a commercial venture by Little, Brown. But Cooper has resigned, Sewell Chan and Eric Dash reported in The New York Times last week (“Staff Losses and Dissent May Hurt Crisis Panel”), following an earlier report of the resignations by Shahien Nasiripour of The Huffington Post. ( It doesn’t help, either, having California Congressman Darrel Issa peering over the Commission’s shoulder in his capacity as the top Republican on the House Oversight and Government Reform Committee.  The FCIC report  clearly will be a close-run thing.)

Meanwhile, behind the scenes, university economists continue to weave together an explanation sufficient to command the widest possible consensus of how a global crash in trade and asset prices eventuated from problems in the subprime mortgage lending sector.

Besides Gorton’s, the most perspicacious of these accounts may be, as Bernanke indicated last week, the work of Markus Brunnermeier, of Princeton University, whose early article in the Journal of Economic Perspectives, “Deciphering the Liquidity and Credit Crunch of 2007-08” is, like the rest of that rejuvenated journal, now available free online.

Tobias Adrian, of the Federal Reserve Bank of New York, and Hyun Shin, of Princeton University, contributed “The Changing Nature of Financial Intermediation and the Financial Crisis of 2007-2009,” in the second volume of Annual Review of Economics.

And Jeremy Stein, of Harvard University, has provided a lucid article on “Securitization, Shadow Banking and Financial Fragility” in a special issue of  Daedalus devoted to the crisis due to appear in October.. .

All agree that the culmination of a thirty-year pulse of financial innovation simply swamped regulators’ abilities to cope with – or even at certain key points to understand – the nature of the unfolding crisis. This vast new infrastructure, known collectively as  the “shadow banking system,” consists principally of the proliferation of investment instruments known as “securitization,” on the one hand; and, on the other, the advent of  myriad other institutional investors including money market mutual funds. There is probably no reason to want to dismantle this system, or even to think any longer that it could be done. But new methods of regulation are definitely needed to prevent the industry from seizing up in panic again a few years hence.

Almost none of the structural problems involved are addressed in the Dodd-Frank Wall Street Reform and Consumer Protection Act, which President Obama signed into law in July. Among a small circle of economists and market participants, the deciphering is nearly complete. But popular news media haven’t yet tackled the task of translating their findings of malfunctions into political discourse. That probably won’t begin in earnest before the FCIC report appears in December.

So perhaps the most interesting occasion on the calendar will be the meeting of the Brookings Panel on Economic Activity scheduled for September 16-17. Gorton and Andrew Metrick, also of Yale, are scheduled to present a paper there – “Regulating the Shadow Banking System” — that includes a concrete proposal to bring the securitization industry under the regulatory umbrella.

How? By chartering – and closely supervising – a new kind of bank (narrow-funding banks) whose sole business would be to buy asset-backed securities from their originators and use them to conduct the banking activities known as “repo” that were at the heart of the 2007-09 crisis.

Sound complicated? It is. Fanciful?  Probably not. It was strict standards for collateral that stabilized national banking in the nineteenth century. The new market will be designed by experts, as opposed to a popular reform. Even so, get ready for more stories  than you will want to read about the mechanics of big-league financial intermediation.

Meanwhile. the last of the big narrative accounts of the most dangerous episode in global finance since the Great Depression is scheduled to appear in November: All the Devils Are Here: The Hidden History of the Financial Crisis, by Joseph Nocera, of The New York Times,  and Bethany McLean, of Vanity Fair. Nocera and McLean are superb storytellers, but they’ll have to stretch to match  at book-length the pungent pith of this column by John Kay in the Financial Times last month, even if, in the interest of economy, Kay had to leave much out. But then that is the nature of columns.

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