Faculty Insights: Fed Chairman Recommends a Paper on the Financial Crisis by Prof. Gary B. Gorton

When one of the key actors in the government response to the financial crisis recommends an academic paper and endorses its thesis, it’s clear evidence that the work of the academy can inform policy. A recent paper by Gary B. Gorton, Frederick Frank Class of 1954 Professor of Management and Finance, has been getting widespread attention. Ben Bernanke, chairman of the Federal Reserve, recommended it, during a recent interview with Washington Post columnist David Ignatius, suggesting its description of the roots of the economic crisis are much in line with his own understanding.

Gorton’s paper, "Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007," takes the position that "The ‘shadow banking system’ at the heart of the current credit crisis is, in fact, a real banking system — and is vulnerable to a banking panic." It goes on to argue that, though earlier panics were retail banking panics and this was a wholesale panic, many features remained consistent. Gorton suggests that drawing on lessons learned, particularly the value of insuring deposits against bank insolvencies, could guide new regulation of the shadow banking system aimed at making it less vulnerable to panic.

Asked about the response to the paper, Gorton said, "Central bankers and regulators seem very sympathetic to my explanation. I am following up with people at the Federal Reserve who have shown the most interest. There is plenty of research to do." But he added that, "The dominant narrative of the crisis, that a few reckless people ‘gamed the system’ has solidified into hardened political positions, so it is hard to make headway with an explanation that is more complicated and is in no one's political interest."

Gorton also said that many academics had been caught flat-footed in proposing ideas for policy or regulatory reform related to the crisis, because they did not study the markets that were at the core of the panic. “It turns out that institutions matter a lot, and that is not what financial economists have really focused on.”

The discussion of Gorton’s ideas quickly expanded to the blogosphere with Ezra Klein devoting a post on his Washington Post blog to summarizing the 53-page paper, which he describes as "very good. Brilliant, even." Additional analysis and commentary appeared on Tyler Cowen’s Marginal Revolution and Arnold Kling’s Library of Economics and Liberty, among other places. A column on Market Watch uses the paper as a jumping off point for discussion of the shadow banking system.

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Gorton discussed the roots of the financial crisis with two other Yale finance professors in the Fall 2008 issue of Qn magazine.