Gary Gorton gave an interview to the FT recently, promoting his new book. There is one very, very, very interesting question and answer section:
Okay, but you can’t be saying that “bad greedy bankers” played *no* role in the crisis, right? That issues like mortgage fraud, lax underwriting, misrepresentations by mortgage lenders to the GSEs, things like the Magnetar and Abacus cases and other items that we’re still picking through should be minimised?
If greedy bankers cause crises, we would have a crisis every week. The Quiet Period from 1934 (when deposit insurance was adopted in the US) until 2007, during which there were no systemic crises, is not explained as being due to non-greedy bankers. What, then, caused bankers to suddenly become greedy? In every crisis in history, it happens that fraud is uncovered. Partly this is due to the fact that everyone asks for their money, and sometimes it cannot be produced (as with Madoff). Other times it is the heightened scrutiny of the financial system that reveals these problems.
I am not saying that these problems are unimportant. But I am saying that an explanation of the recurrence of systemic financial crises throughout the history of market economies cannot be explained by greed or fraud, etc. These are not explanations of crises and they are not the central problem. We are talking about systemic crises: that is crises in which the entire financial system is at risk. In Bernanke’s testimony before the U.S. Financial Crisis Inquiry Commission, he said that 12 of the 13 largest financial firms in the US were about to fail. How exactly does greed cause that, but it did not during the Quiet Period?
The question was not answered by the interviewer of the FT, but it is most relevant for academic economists. Adam Smith says that greed is more or less good, if it is expressed through a market system. In order to make the market work you need regulation, because otherwise you get to live in a world ruled by fraud, or, violence.
It is here that I would bring in Hyman Minsky’s idea that stability breeds instability. During the robber baron era of the 1920s, greed led to inequality, then the Great Crash of ’29 and the Great Depression. It was understood that the financial sector needs to be regulated so that people do not gamble away their livelihoods because this has external effects. If I lose my shirt and liquidate, asset prices will drop and that will lead to other people losing their shirt. Since debt is build on other debt, this effect is an essential feature of financial capitalism. Hence, the total amount of debt should be low.
Hyman Minsky then wrote during the Quiet Period of 1945-2007 (Gorton’s name for it) the lack of instability caused greedy bankers to be able to pull down those regulations. The Glass-Steagall act was repealed step by step, with the last push coming in 1999. So, stability led to instability, and we ended up with basically the same problem as in the Great Depression: bank runs, which is what Gary Gorton described.
The insight that the ‘system’ keeps in check the ‘animal spirits’ of men is one that Europeans have learned through the building of European institutions, which led to a period of relative tranquility on the (sub)continent. Designing institutions is also no stranger to the US political system, where checks and balances exist in order to block a small minority to rule over the majority. Any serious solutions to the problems of today must build on that insight.