Misunderstanding Financial Crises: Why We Don't See Them Coming

Misunderstanding Financial Crises: Why We Don't See Them Coming

Misunderstanding Financial Crises: Why We Don't See Them Coming

Misunderstanding Financial Crises: Why We Don't See Them Coming


Before 2007, economists thought that financial crises would never happen again in the United States, that such upheavals were a thing of the past. Gary B. Gorton, a prominent expert on financial crises, argues that economists fundamentally misunderstand what they are, why they occur, and why there were none in the U.S. from 1934 to 2007.

Misunderstanding Financial Crisesoffers a back-to-basics overview of financial crises, and shows that they are not rare, idiosyncratic events caused by a perfect storm of unconnected factors. Instead, Gorton shows how financial crises are, indeed, inherent to our financial system. Economists, Gorton 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. Comparing the so-called "Quiet Period" of 1934 to 2007, when there were no systemic crises, to the "Panic of 2007-2008," Gorton ties together key issues like bank debt and liquidity, credit booms and manias, moral hazard, and too-big-too-fail--all to illustrate the true causes of financial collapse. He argues that the successful regulation that prevented crises since 1934 did not adequately keep pace with innovation in the financial sector, due in part to the misunderstandings of economists, who assured regulators that all was well. Gorton also looks forward to offer both a better way for economists to think about markets and a description of the regulation necessary to address the future threat of financial disaster.


The effects of the financial catastrophe through which the country
had passed in the previous period were seen in legislation for
perhaps a decade, but then they were gradually forgotten. The
literature of this subject for fifty years had repeated the same
inferences, lessons, and warning; but all the doctrines of currency
have to be learned over again apparently every ten or fifteen years, if
indeed they were ever learned at all.

—William Graham Sumner, A History of Banking in the United States, 1896

William Graham Sumner (1840–1910), a Yale professor and expert on banking, was describing the half century prior to the U.S. Civil War. the next seventy or so years after the Civil War were marked by repeated financial crises until federal deposit insurance legislation was passed during the Great Depression, and could be described similarly. the global financial crisis of 2007–8 suggests that the lessons were probably never learned. What are the lessons?

One is that financial crises are inherent in the production of bank debt, which is used to conduct transactions, and, unless the government designs intelligent regulation, crises will continue. This is not understood. Prior to the financial crisis of 2007–8, economists thought that no such financial crisis would ever happen again in the United States. Economists thought that a crisis could not happen. Then the unthinkable happened; the inconceivable happened. How could economists, myself included, have been so wrong?

Economists misunderstand financial crises, what they are, why they occur, why we didn’t have one in the United States between 1934 and . . .

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