Some Quibbles on Gorton (2012)

The title is referring to Gary Gorton, Misunderstanding Financial Crises (Oxford: Oxford University Press, 2012). This post is a collection of “complaints,” as I read through the book. More than “complaints,” these are points of contention. This is largely meant to keep track, but also for the sake of stirring up conversation. Also, these are likely to reappear in any review I write of the book, and it’s worth hashing out these ideas (for example, in case I’m missing something). Finally, these quibbles shouldn’t imply that the book is “bad” or not worth reading. Whatever my issues are, this is an incredibly interesting and informative book (like most of Gorton’s work).

1. Private information insensitive debt

Gorton holds that private banks cannot create information insensitive debt. He doesn’t offer any evidence of this, except for the fact that state banks during the “free banking” era, in the United States, could not create information insensitive collateral. Gorton explains information sensitivity as the degree to which it pays to know “secrets.” I don’t like this definition; more than about knowing, it’s about uncertainty. Collateral is information sensitive when you’re not sure of the true value — when market “signals” suggest that the collateral backing debt is unsafe. Since the National Banking era, that collateral has been Federal public debt, which in the United States has historically been “information insensitive” (Gorton writes as if this were a sure thing, but Federal public debt would be “information sensitive” if there were a risk of sovereign default, for instance).

Prior to the U.S. Civil War, some states passed “free banking” laws. Gorton explains that these laws required banks to back their money substitute with state bonds; but, these were not always information insensitive (e.g. if the state was suffering from fiscal problems) and so most of the time notes would trade under par (also, given the era, they’d also have to factor in distance from the issuing bank, et cetera). But, then, he goes on to blame this on the inability of private banks to create information insensitive debt. I don’t understand, because the “private market” does have information insensitive collateral: outside money (e.g. gold, silver, et cetera). No less, the ability to produce alternatives is severely handicapped when one of the conditions of being granted a charter is to back liabilities with a specified bond, in this case state bonds.

This being said, something Gorton doesn’t directly point out is that information sensitive collateral may be useful. Let’s say that a bank has reached its limit on fiduciary extension backed by outside money, so it decides to use different forms of assets (e.g. asset backed securities). Information sensitivity is a form of market discipline, where notes trading below par signal over-issue by the banks: it limits credit expansion.

But, my main point is that outside money is information insensitive (unless there are wild fluctuations in its supply, but “hard money” evolved largely to avoid these transaction costs). Why doesn’t Gorton consider it?

2. Moral hazard

I’m sympathetic to the notion that moral hazard, in banking, is not as relevant as some people assume. But, one of the arguments used by Gorton, I think, is ridiculous. He invokes an economist by the name of T. Bruce Robb, arguing that moral hazard is irrelevant because depositors don’t know enough to discipline banks anyways. Again, I’m somewhat sympathetic, and I can see it as relevant to an extent. What bewilders me is that Gorton doesn’t realize that the notion of information sensitivity undermines this argument. Notes trading below par are examples of depositors disciplining their banks: banks with notes trading below par are likely to get less business, and in fact customers will probably opt to withdraw their outside money and re-deposit it in a safer bank (one with higher value notes). This, of course, is another advantage of competitive note issue (that Gorton doesn’t consider).

3. Liabilities v. assets

I have to find the exact page number, although it’s a subtle theme throughout the book, but Gorton emphasizes the liabilities side of banks’ balance sheets more than the assets side. His reasoning is that financial crises are mostly about banks being unable to meet their short-term liabilities — that is, banks become illiquid. While he casually mentions this during his description of certain historical cases, the fact is that banks have a hard time meeting short-term obligations only because their assets have deteriorated in value. Specifically, short-term credit markets dry up because the collateral banks offer in return is information sensitive, which really means that their value is suspect and their liquidity declines. The assets side is just as important as the liabilities side.

One issue is that by overemphasizing the liabilities side, Gorton seems to suggest that crises are, in a sense, forced on banks. For example, he explains the Livingston Doctrine, which holds that banks during crises are really illiquid, not insolvent, and so should be bailed out (including temporary suspension of redemption and bank holidays). I’m not questioning the value of these measures, rather what I’m drawing attention to is that financial crises are as much about assets as they are about liabilities. In fact (actually, as Gorton’s book shows), crises are usually caused by a deterioration of banks’ assets, since the values of these are directly related to “market fundamentals.” Similarly, Gorton writes that banks have a hard time turning illiquid assets liquid, because “fire sales” invariably lead to drastic declines in assets’ prices. But, these declines are “efficient,” in the sense that they force banks to price assets reflecting the true nature of their risks (although, admittedly, fire sales can push assets’ prices down below their clearing price). We have plenty of competing theories that all agree that much of this deterioration is caused by the banks themselves: either through bad loans, or through price distortions.Misunderstsanding Financial Crises (Gorton)

I don’t think this quibble is particularly important (although, I have to re-read some sections of the book to better remember some of the implications that Gorton drew from his emphasis on the liabilities side). Nevertheless, it’s as strange an error on Gorton’s part as the previous two points. This being said, near the end of the book, Gorton does make a good point: many assets unrelated to subprime mortgages, and, in any case, those which actually had a heightened propensity for failure, also fell in value. He makes the case that changes in expectations also undermined the value of assets which weren’t at risk, such as those securitizing school loans, credit card loans, car loans, et cetera. I’m not at home, so I can’t look at some sources I have in mind, but I have some skepticism because I thought that most investment banks, what Gorton calls “dealer banks,” mostly held mortgage-backed securities — I’ll have to confirm this when I get back home (or someone can do it for me!).

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