Did an invisible run on banks kill the economy?

The problem behind the financial crisis was not what we think, says Gary Gorton. Interview by Ben Schreckinger

Gary Gorton, Yale University economist and author of Misunderstanding Financial Crises: Why We Don’t See Them Coming
Oxford University Press
Gary Gorton, Yale University economist and author of Misunderstanding Financial Crises: Why We Don’t See Them Coming

Four years after the last financial crisis came to a head, it remains an open question whether the US economy is safe from a repeat. The answer depends on another question: What caused the crisis in the first place?

Fault for the crash lies, according to various popular theories, with some combination of over-leveraged banks, a culture of greed on Wall Street, the collapse of mortgage-backed securities, and financial institutions that are too big to fail. But according to Yale University economist Gary Gorton, all of these explanations are wrong, and regulators have done nothing to address the underlying cause of the meltdown.

In “Misunderstanding Financial Crises: Why We Don’t See Them Coming,” published last month by Oxford University Press, Gorton argues that the true culprit was actually a kind of bank run—but not a visible Depression-era bank run, with citizens banging on doors trying to get their money out. Rather it was a run on the “shadow banking system,” a huge, largely unregulated system in which an immense amount of money changes hands daily, all behind the scenes. This “shadow” system is perfectly legal; it funds traditional banking, and the two are deeply intertwined. But its transactions are unregulated and invisible on banks’ balance sheets—so when a crisis of confidence strikes, as it did in 2008, a surprised government must turn to drastic and risky tactics to stanch it.


The shadow banking system still exists, with large financial institutions quietly borrowing and lending money in massive short-term arrangements known as sale-and-repurchase agreements. Although there aren’t definitive measures, the most recent estimate by an international group of regulators put it at $67 trillion worldwide—roughly two-thirds the size of traditional banking.

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Gorton is a scholar of financial crashes, and he doesn’t see the most recent meltdown or the one that kicked off the Great Depression as anomalies. Instead, he views the seven crash-free decades between the two as a rare period in which bank regulations were adequate to prevent catastrophic bank runs. And because no new rules have emerged to address the new kind of run that triggered the recent crisis, he says, we could be in for a repeat every few years.

Ideas spoke with Gorton by phone on two occasions from his office in New Haven.

IDEAS: When we think “bank run,” we think of customers mobbing bank buildings. What happened during this crisis?

GORTON: The way it worked was instead of people lining up at banks, people would use the phone or e-mail or Bloomberg Mail, and they would say, “I’m not going to lend my money again. Give it back to me.” And so in the sale-and-repurchase market, about $1.2 trillion was withdrawn in a very short period of time....It just happened that depositors were not individual households, they were institutional investors and other firms.


IDEAS: That’s not the explanation we’ve been hearing.

GORTON: The reason for this I think is in large part because people didn’t see what happened. No one saw a bank run like in “It’s a Wonderful Life.” They only saw the effects of the bank run. They saw firms get into trouble, and they saw house prices go up, but they’ve been unable to connect all this into a coherent picture of what actually happened. And that means that everybody still seems to be quite confused.

IDEAS: A lot of experts say the financial crisis was caused by bankers creating a subprime mortgage bubble. That’s not it?

GORTON: That’s simply not big enough to explain what happened, and in fact the losses on all triple A subprime mortgages are minuscule....That might be thought of as a triggering event, but that by itself does not explain what happened, and that gets wrapped up in that whole notion about bankers—that somehow greedy bankers were at the root of this. People may not like bankers, and people may think they’re greedy, but I can tell you that if greedy bankers explain the crisis, then we would have financial crises every other week.

IDEAS: Why do economists and lawmakers overlook this as the cause?


GORTON: Since the only people who saw it were people on trading floors, I think it’s hard for people to accept an abstract idea about what happened.

‘If greedy bankers explain the crisis, then we would have financial crises every other week.’

IDEAS: Isn’t that what economists are supposed to be good at?

GORTON: Most economists, you have to understand, don’t have any direct experience in the world. They went to college, then they went to graduate school, then they went to teach....They were basically learning it at the same time every one else was learning it.

IDEAS: Are you in the same boat?

GORTON: My PhD thesis was on banking panics almost 30 years ago, and all my research also has been on banking panics, and I was a consultant to AIG financial products for 12 years. I was there. I saw it.

IDEAS: You’ve argued that we need a whole new category of banks, with their own collateral rules. It’s been four years. Why don’t we have them already?

GORTON: We didn’t figure out fast enough what had happened, and it was difficult to disseminate the information so legislation was hurried. The legislation, Dodd-Frank, happened before the Financial Crisis Inquiry Commission had finished.

IDEAS: Do you expect we’ll get this type of regulation in time to prevent the next crisis?

GORTON: I’m not particularly optimistic, no. In the book I talk about what I think are the most important legislative successes in financial history in the US. That is deposit insurance and before deposit insurance the National Bank Acts, passed during the Civil War. And neither of these acts was passed because people carefully considered them and thought they would be good ideas. The National Bank Acts were passed to help the North finance the Civil War, and deposit insurance was passed as a populist demand.

IDEAS: Are you discouraged by the lack of progress so far?

GORTON: On the one hand, it’s kind of depressing that we had this huge disaster and what we got out of it was a book by Michael Lewis, and not a lot else. On the other hand, historically it takes a lot of time for ideas to sink in.

IDEAS: President Obama, who campaigned in 2008 as a Wall Street reformer, has been reelected, and just this month Federal Reserve Board Governor Daniel Tarullo called shadow banking regulation “the most important remaining task of financial regulatory reform.” So now will we see action?

GORTON: I don’t think anything’s going to happen....We’re in a world where we need a lot of education before we get to the point where people really entertain solutions.

Ben Schreckinger is an Atlantic Media fellow reporting for National Journal. He can be reached at and @BenSchreckinger.