Prior to the financial crisis of 2007-2008, economists thought that
no such crisis could or would ever happen again in the United
States, that financial events of such magnitude were a thing of the
distant past. In fact, observers of that distant past-the period
from the half century prior to the Civil War up to the passage of
deposit insurance during the Great Depression, which was marked by
repeated financial crises-note that while legislation immediately
after crises reacted to their effects, economists and policymakers
continually failed to grasp the true lessons to be learned. Gary
Gorton, considered by many to be the authority on the financial
crisis of our time, holds that economists fundamentally
misunderstand financial crises-what they are, why they occur, and
why there were none in the U.S. between 1934 and 2007. In
Misunderstanding Financial Crises, he illustrates that financial
crises are inherent to the production of bank debt, which is used
to conduct transactions, and that unless the government designs
intelligent regulation, crises will continue. Economists, he
writes, looked from a certain point of view and missed everything
that was important: the evolution of capital markets and the
banking system, the existence of new financial instruments, and the
size of certain money markets like the sale and repurchase market.
Delving into how such a massive intellectual failure could have
happened, Gorton offers a back-to-basics elucidation of financial
crises, and shows how they are not rare, idiosyncratic, unfortunate
events caused by a coincidence of unconnected factors. By looking
back to the "Quiet Period " from 1934 to 2007 when there were no
systemic crises, and to the "Panic of 2007-2008, " he brings
together such issues as bank debt and liquidity, credit booms and
manias, and moral hazard and too-big-too-fail, to illustrate the
costs of bank failure and the true causes of financial crises. He
argues that the successful regulation that prevented crises did not
adequately keep pace with innovation in the financial sector, due
in large part to economists' misunderstandings. He then looks
forward to offer both a better way for economists to conceive of
markets, as well as a description of the regulation necessary to
address the historical threat of financial crises.
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