Lucas once said that business cycles are all alike. Gorton wants to focus on what makes financial crises all alike. His key point seems to be that, in any financial crisis, we can find a run. In the United States, bank runs were a key feature of panic episodes during the National Banking era (1863-1913) and the Great Depression. Bank runs were certainly not a feature of the recent financial crisis, but Gorton thinks that "repo runs" were essentially the same phenomenon.
Gorton's idea is that any financial entity that intermediates across maturities can be subject to a run. The Diamond-Dybvig view is that bank runs are inherent to the liquidity transformation carried out by banks. A well-diversified bank transforms illiquid assets into liquid liabilities, subject to withdrawal. Everything is fine unless depositors anticipate that others will run on the bank, in which case we find ourselves in a bad equilibrium - a bank run. In the run equilibrium, it is optimal for each depositor to run to the bank to withdraw his or her deposit, since their best hope in this equilibrium is to get to the bank before the assets are exhausted.
A shadow bank is not quite like a Diamond-Dybvig bank. A typical shadow bank holds long-maturity liquid assets and finances its portfolio by rolling over short-term repos (repurchase agreements), using the underlying assets as collateral. One might think that, because the shadow bank's assets are liquid, a run could never occur. If financial market participants are reluctant to roll over the shadow bank's repos, it can sell assets to pay off its debts. The problem arises if there is a systemic revaluation of shadow bank assets. Then, an individual shadow bank could default because new repo holders are demanding large haircuts in their repo contracts. Worse, since all shadow banks are selling assets simultaneously, the prices of assets are further depressed (a fire sale), which amplifies the repo run.
A debt contract is an efficient arrangement that works extremely well in good times. The payments required under a debt contract are non-contingent, and there is no fuss about what it means to fulfill the terms of the contract. Problems occur in default states, however, particularly when there are multiple creditors. For a bank, the coordination problem that arises in the event of default is particularly severe, given the large number of small depositors. However, coordination can be very costly even if a financial institution's creditors consist of a few other financial institutions. In a Diamond-Dybvig model, coordination is formalized as "sequential service," which inhibits communication among the bank's depositors in a rather brutal fashion. Of course, a shadow bank run really has nothing to do with creditors "lining up" at the shadow bank, so we can't take sequential service literally if we want to think of repo runs as akin to Diamond-Dybvig runs.
Coordination costs that arise in a default involving multiple creditors are reflected in legal costs, and the time that assets are tied up in litigation. In the case of banking, deposit insurance minimizes those costs in a nice way. The FDIC stands in for all creditors, thus eliminating the replication of default costs among creditors and doing away with disputes among creditors. Further, resolution occurs quickly. Of course, we all know about the fallout from insuring the liabilities of financial intermediaries. Absent constraints on risk-taking, insurance creates a moral hazard problem, whereby intermediaries take on more risk than is socially optimal.
So if, as Gorton suggests, a financial crisis is defined by widespread runs on financial intermediaries, how is that helpful?
1. Does this mean that central banks should respond to every financial crisis in the same way? Probably not. Banking panics in the National Banking era and the Great Depression were essentially currency shortages. The recent financial crisis involved a shortage of safe assets, more broadly. A currency shortage can be solved with a central bank open market purchase of government debt. A shortage of safe assets may be a problem for fiscal policy - as asset swaps by the central bank will not change the net supply of safe assets. Further, central bank lending policies may depend on the particulars of the crisis.
2. If we think of a financial crisis as a run problem, and draw an analogy to banking and deposit insurance, this must mean we should insure everything that looks vaguely like banking. Moral hazard everywhere. Great.
3. One of the lessons of the financial crisis is that financial factors are important. Surprisingly, many people once thought otherwise, and some continue to think so. But the importance of financial factors is not confined to the events we want to call "financial crises." It seems wrongheaded to take episodes in history and put them in "crisis" and "non-crisis" bins.
You can see how fussing over what is a financial crisis and what is not can be unproductive. Case in point:
1. Reinhart and Rogoff define a financial crisis in a particular way, and argue that there is a regularity in the data. Recoveries after financial crises are protracted. People use that "fact" in different ways. Jim Bullard wants to argue that the Reinhart-Rogoff regularity tells us that the Fed should not held responsible for the slow recovery. Paul Krugman wants to use the Reinhart-Rogoff regularity to absolve the Obama administration. Of course, he is walking a fine line here as, in contrast to Bullard (apparently) he seems to think that appropriate monetary and fiscal policy would have left Reinhart and Rogoff with no regularity to talk about.
2. Mike Bordo and Joe Haubrich define a financial crisis differently (from Reinhart and Rogoff) and argue that, in the United States, it's hard to argue that the Reinhart/Rogoff regularity is in the data. Sometimes we see it. Sometimes we don't. John Taylor picks up on this. Like Krugman, he has an ax to grind - different ax though. According to Taylor, things are worse than they should be because of you-know-who.
Taylor does point out something useful, though, and quotes Bordo:
The mistaken view comes largely from the 2009 book “This Time Is Different,” by economists Carmen Reinhart and Kenneth Rogoff, and other studies based on the experience of several countries in recent decades. The problem with these studies is that they lump together countries with diverse institutions, financial structures and economic policies.That's important. The U.S. financial system is unique in many ways. It still has many small banks; U.S. financial regulation is unusually complicated, with a confusing patchwork of overlapping regulatory authority; the U.S. supplies the world's reserve currency; the Fed intervenes in different ways because of peculiarities in our financial markets. The comparison with Canada is useful. Canada and the U.S. are similar in many ways, but it is difficult or impossible to find anything that Reinhart-Rogoff or Bordo-Haubrich would call a financial crisis, in all of Canadian history. How come? They have debt contracts, banking, and financial intermediation across maturities in Canada. Why no panics?
Why indeed. Definitions and data give us something, but they can't substitute for theories that can help us organize our thinking about the data. The immediate question is whether or not the monetary and fiscal authorities in the United States are doing the appropriate things. There are good reasons to think that recessions are not alike, and that the most recent recession has features that are different from previous ones in the United States - and different in important ways from episodes where we think that there was some element of "financial crisis." Even if we could figure out the Great Depression, and understood completely the policies that would have been appropriate at the time, that would be no guarantee of success under current conditions.
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