An Odd Couple

All that summer of 2008, decision-makers in Washington, D.C., were hoping for a soft landing – or so they said at the time. That was, after all, what happened in 1998, after the Russian debt crisis; or in March 2000, when the dot-com bubble collapsed. That speculative frenzy in tech-stock prices was punctured in the usual fashion, by upward pressure on interest rates applied by the Federal Reserve Board. NASDAQ prices crashed but nothing else did – an eight-month recession was barely noticeable, before the economy was growing again. Now there was a housing bubble. So the authorities hoped that gently rising rates would produce the same result – and then only after the November election

To be sure, there had been a credit crunch the summer before.  Some hedge funds in New York and London got in trouble. A French bank required government assistance. In Newcastle-on-Tyne, depositors lined up outside Northern Rock’s home office to withdraw their funds, the first run on a British bank in 150 years. But the depositors were paid off by government insurance; the hedge funds were quietly closed or merged into better-capitalized competitors. The Fed cut its short term interest rate by half a percent, markets soared, and attention shifted to the Mideast, soaring food and energy prices. In January White House economists had predicted strong growth later that year, but, just in case, president George W. Bush took out some insurance.  He promoted and signed a stimulus bill – tax rebates of as much as $1200 for a married couple

Behind the scenes, central banks had quietly spread new safety nets: A term–auction facility was announced, though hardly anyone understood why it was needed; swaplines were established, though few recognized what they implied. Treasury Secretary Henry Paulson tried selling Wall Street on a voluntary self-rescue plan, with no success. The forced sale of Bear Stearns to J.P. Morgan in March reinforced the conviction, at least among outsiders, that the Fed was in control. In April, Paulson’s staff began working feverishly on a bank recapitalization plan they code-named “break the glass.”  But this was successfully kept secret. The general expectation was that the “great moderation” the Fed had engineered would continue.  It was now nearly twenty-five years old.

So much else was in the headlines in 2008. The Democratic primaries in the winter and spring were close-run contest between Senators Hillary Clinton and Barack Obama. Not until late May did Obama cinch the nomination.  So as the Beijing Olympics wound down and Russia went to five-day war in Georgia over NATO expansion plans, and John McCain added Sarah Palin to the Republican ticket out, sophisticated observers expected the Fed to begin raising rates by the end of the year, with another mild recession to follow. Overbuilding might still preoccupy newspapers and business magazines, but Mark Zandi, of Moody’s Corp., declared in July that “the worst of the crisis seems to be over.” Fed chairman Ben Bernanke told a visitor to his office in August, “A lot can still go wrong, but at least I can see a path that will bring us out of this entire episode relatively intact.”

So when 130 central bankers, finance ministers, policy academics, and financial market participants gathered towards the end of August for the closely-watched annual symposium of the Federal Reserve Bank of Kansas City in Jackson Hole, Wyoming, the public stance was one of cautious optimism. The lead presenter, Charles Calomiris, the Henry Kaufmann Professor of Financial Institutions at Columbia Business School, concluded his remarks, “The American financial system, if it remains true to its history, will adapt and innovate its way back to profitability and high stock prices sooner than is suggested by the dire predictions that fill today’s newspapers.

.                                                 An Entrepreneurial Historian

Second on the program that day was Gary Gorton, who was introduced in Economic Principals last week. An economic historian but He was about to begin teaching at Yale University’s School of Management, after having spent more than twenty years at the Wharton School of the University of Pennsylvania.  Gorton’s assignment was to deconstruct the period of market turbulence that shocked market participants but otherwise barely made the front pages. The title of his paper, “The Panic of 2007,” reflected something of his argument:  What happened in those few weeks the year before had, at least to those affected by it, “seemed like a force of nature, something akin to a hurricane or an earthquake, something beyond human control. In August of that year, credit markets ceased to function, like the sudden arrival of a [situation] in which no one would trade with you simply because you wanted to trade with them.”

Gorton, b. 1951, had traveled a long way to arrive at Jackson Hole. He had graduated from Oberlin College, in 1973, with a preference for Marxist economics and a taste for art.  After obtaining a master’s degree in Chinese Literature at the University of Michigan, he quit academia and worked for three years, first as a union organizer in Ann Arbor, then as a cabdriver in Cleveland, before deciding to go to graduate school in economics. He learned the necessary math in night school at Cleveland State University over the course of a year, then was admitted to the University of Rochester, known then as a demanding finishing school. Only a handful of the twenty-seven who enrolled in the doctoral program that year ultimately completed their PhDs. His principal advisor was Stanley Engerman, the celebrated economic historian; his dissertation, three essays on banking panics in the nineteenth century, included an empirical study urged upon him by committee member Robert Barro.

In 1981 Gorton took a job at the Federal Reserve Bank of Philadelphia, across the street from first Bank of the United States, the one that Alexander Hamilton founded; he walked to work past the second, the one headed by Nicholas Biddle until Congress permitted its charter, too, to lapse. Friends disparaged FRB Philadelphia as the a backwater of a backwater, but Gorton had become an economist to study banking and only New York offered a closer look at how it was practiced in the present day.  (It was also the city in which he had grown up, with three brothers, in a close-knit family.) In 1984 he  moved across the Schuylkill River in 1990 to teach at the Wharton School, the next year publishing “Private Bank Clearing Houses and the Origins of Central Banking,” an article related to his dissertation. Thereafter appeared an increasing stream of papers, including “Financial Intermediaries and Liquidity Formation” (written with George Pennachi), an information-based model of debt that would become important to him in 2008, and, in 1994, the prescient “Bank Regulation when Banks and Banking are Not the Same,: about the rise of the shadow banking system.

One other qualification led to Gorton being invited to Jackson Hole that day:  since 1996, he had consulted to AIG-FP, the skunk works that had been set up by the giant insurance company after the 1987 market break to seek new opportunities. The ’87 crash, and the growing complexity of the securities markets it disclosed, catalyzed the formation of many new private equity ventures, hedge funds, and money management firms, including BackRock. AIG  had long had a big stock-lending business. AIG’s AAA credit rating meant that, much like a bank it could borrow and lend more cheaply than other financial firms.  Before long AIG-FP  was writing credit default swaps, a new form of derivative pioneered by J.P. Morgan as a form of insurance against credit risk. By 2008, AIG-FP had become a powerful contributor to earnings, based in part on the businesses in which Gorton was involved. Nearly every Monday for twelve years, he had driven up I-95 to Westport, Conn., in order to create all manner of models of credit risk.

Policymakers had restored a simulacrum of normalcy to markets in the autumn if 2007;  but after August, Gorton had become alarmed, frightened, and finally terrified by developments. He put his family’s home, in Newtown, Pa., west of Philadelphia, up for sale, and sold his Maserati. He resumed teaching at Wharton, but sought to join his friend and collaborator Andrew Metrick, who had moved to Yale. That winter Gorton bought a house in New Haven before he had an offer, an emphatic way of demonstrating that he wasn’t merely shopping for a higher offer with which to browbeat his Wharton dean. The ploy worked: he obtained a job. He moved his family to New Haven.

With the peril rising, Gorton didn’t know which way to turn.  He sought to interest the Financial Times and the Wall Street Journal in an op-ed. Who really believed that pumping $150 billion in personal tax cuts would solve the problem? Instead the Treasury should extenda line of credit to Fannie and Freddie sufficient to refinance adjustable subprime mortgages at the teaser rates, absorbing the difference itself. That would make the subprime go away.  Not surprisingly, the idea went nowhere.  He  explored the possibility of quitting AIG-FP to start a fund with friends himself, to take advantage of the developing disorder, either in credit markets or in commodities.  To that end he began to write a lengthy offering document, in which he explained the mortgage-backed securities markets in considerable detail. The plans evanesced.  When the Kansas City Fed asked if he would write a paper on the subprime crisis for the Jackson Hole conference, he had 60 pages already written.

Economists had warned before at Jackson Hole that trouble was brewing. In 2005, Raghuram Rajan, of the University of Chicago’s Booth School of Business, had asserted that financial innovation was making the world riskier. Rajan’s discussant, Hyun Song Shin, then a professor at the London School of Economics, had told the story of how the Millennium Bridge over the Thames had to be closed and re-engineered to eliminate a self-amplifying wobble (“synchronous lateral excitation!”), a parable of people responding to their environment. (Lawrence Summers, of Harvard University, ridiculed Rajan, saying he found “the basic, slightly Luddite premise of this paper to be largely misguided.”)  In 2007, Paul McCulley, a senior figure from at the giant bond investor PIMCO, got the attention of the crowd when he praised the Fed for doing “an absolutely fantastic job” with the official banking system, but  warned “the real issue going on in THE? marketplace right now is a run on your shadow banking system.”

Gorton’s paper was different. It described in detail how the bursting of a housing bubble could set off a crisis in the financial system itself.  For more than a year, anyone who read the financial pages carefully understood that subprime mortgages, intended to allow poorer people and riskier borrowers to own their homes, had become a problem for financial markets. Gorton identified and explained the aspect that made subprime mortgages so different from and more dangerous than everything else: “dynamic tranching as a function of excess spread and prepayment” meant that they depended on house prices going up,  prices which now were rapidly falling. Much of Gorton’s discussion that day is familiar now, at least to anyone who has read any of the series of excellent journalistic accounts of financial innovation that have appeared since the crisis. But his explanation of RMBS, CDO, ABS, CMBS, SIV, ABCP, CDS, the ABX index, and the LIBOR-OIS spread fell on deaf ears that day.

What Gorton didn’t describe that day in any detail was the new system of collateral banking that had developed in the years since 1987. He didn’t because the panic hadn’t happened yet; it wasn’t particularly germane. Over the course of the last twenty-five or thirty years, bankers and institutional investors had invented A whole new system of wholesale banking, one which revolved around a new form of money – sale and repurchase agreements, or repo – for those with big sums of money to lend – to deposit – but only for a little while.  These deposits were far too large to be guaranteed by government insurance. Instead they were guaranteed by complicated packages of debt held in bond as collateral, in principle only overnight. If the debt were not repaid – the deposit returned – then the repo was said to fail, the depositor would keep the collateral, and both parties would move on with no hard feelings. Repo was no less money than were demand deposits, or private bank notes before the Civil War; repo just wasn’t very widely understood.  It was this highly liquid market that would practically evaporate when “depositors” tried to take their money out of the repo-banking system all at once.  But all this lay in the future – three weeks, to be precise.

So Gorton told the audience at Jackson Hole about the run  on the system that had begun the year before, in August – the Panic of 2007, he called it. It hadn’t ended; it had merely been contained. Now it was getting worse.  He was a fluent speaker of the language of economics who also possessed an insider’s mastery of the mechanics of the looming crisis. But Gorton’s presentation failed to get the bankers’ attention. Eyes glazed over at the detailed descriptions.

.                                                  A Worldly Theorist

Each speaker at Jackson Hole was assigned a discussant, an authority who was expected to add something to the discussion from an opposing point of view.  Assigned to comment on Gorton’s paper was Bengt Holmström, of the Massachusetts Institute of Technology, another unlikely participant in the meeting at Jackson Hole (and also introduced here last week). Holmström was a theorist, a major player in the exciting development in the economics of organizations that had swept through the ’80s, both in economics and in the markets for corporate control. He was a senior figure in information economics,  but hardly the sort of figure you would expect to find at a meeting devoted to macroeconomic and monetary policy.

Born in 1949 to a Swedish-speaking family in Finland, Holmström grew up with a well-developed a sense of Finnish pride.  He served the required year in the Army and graduated from the University of Helsinki, in 1972 with a degree in math and minors in theoretical physics and statistics, then worked for two years as an analyst for a large Finnish conglomerate, with  paper and pulp at its core.  His job was developing planning models for the CFO, a subtle business of deciding what to measure, A Fulbright fellowship, in 1974, took him to Stanford University, to obtain a master’s degree in engineering and operations research.  He had married into a family-owned recycling business and expected to return home in a year with his wife and their infant son.

Economics at Stanford in those days had entered a period of intense ferment, as developments in game theory, operations research, law and economics, and the freshly dubbed field of “mechanism design” converged and competed for problem-solvers’ attention. Holmström was quickly recognized as an unusual talent; the Graduate School of Business arranged to keep on Holmström as a doctoral student.  Stanford professor Robert Wilson took him under his wing, along with Paul Milgrom. David Kreps and Alvin Roth had received their GSB degrees a year or two before. Kenneth Arrow returned to Stanford every summer from Harvard for the sessions of the Institute for Mathematical Studies in the Social Sciences arranged by professor Mordecai Kurz  – an incubator, along with the decentralization conferences that had begun at the University of California at Berkeley, in 1970, in which a good portion of economics would be transformed.

Some of the excitement had to do with industrial organization; deregulation and antitrust problems were in the air; some had to do with the organizations themselves. As a corporate planner, Holmstrom had learned to think about managers’ incentives, and how they might be structured for better results.  Milgrom was interested in a somewhat similar problem: auctions, and how they might be arranged to elicit more and better information. The two were party to what economists experienced as an intellectual revolution.  A field that for two centuries had been defined by its preoccupation with prices and quantities would be reborn in the space of little more than a decade as a study of incentives of all kinds, thank to the interpretation of equilibrium set out out in 1950 by mathematician John Nash.  (See this lucid explanation by Kevin Bryan, of the University of Toronto, of Nash’s concept and its slow dawn.) Holmström locked himself in a room  fourteen hours a day and produced the manuscript of a small book, from which three papers would quickly tumble and, eventually, many more,  beginning with a nineteen-page classic in the Bell Journal of Economics, Moral Hazard and Observability, in 1979. Milgrom left Stanford for Northwestern the following year.

If Holmström had entered economics accidentally, through the back door, he exited Stanford through the front, to a post-doctoral fellowship at the Center for Operations Research and Econometrics, at Belgium’s University of Louvain. He returned to Finland the next year, to the Swedish School of Economics in Helsinki, where Wilson, visiting from Stanford, found him all but marooned. He persuaded Holmström and his wife to return to the US. Northwestern quickly hired him; he spent the next three years nestled in another hotbed of information economics that included Milgrom, Nancy Stokey, John Roberts and Roger Myerson.  Milgrom then lured him to Yale, and the excitement began to move east. By now the Princeton economics department had joined the chase.

In 1993, the economic department at the Massachusetts Institute of Technology was rocked by a series of defections to Harvard, including Oliver Hart, Drew Fudenberg and Martin Weitzman (Eric Maskin had returned to Harvard in 1985). At the heart of the exodus was a struggle over the transformation that had begun in California two decades two before. Holmström was called the following year to rebuild MIT; and in the next ten years he and the others who remained managed to stabilize MIT’s reputation in its contest with Harvard to attract the best entering graduate students in economics.

Thus the contrast with Gorton that day in Jackson Hole could hardly have been greater:  the one, an economic historian of banking with a great deal of present-day practical knowledge of markets for securitized debt; the other a star theorist of incentives and information.

But Holmström was in Jackson Hole because in the last decade he had become a contributor to the literature on banks and liquidity. With his friend Jean Tirole, he had  published “The Private and Public Supply of Liquidity” in 1998, arguing that perhaps the capacity of government to tax must play a vital role in resolving financial crises – perhaps a clearer formal argument about the need for central banking than had  ever before appeared in the literature. The work had been inspired by Holmström’s experiences in the Scandinavian banking crisis of 1993, when a housing bubble threatened the solvency of many banks, and the dissolution of the Soviet Union posed a special threat to the Finnish economy. So in the summer of 2008 Holmström once again was deeply interested in both the theory and practice of banking. He phoned Gorton weekly to learn what he planned to say. The two had worked together briefly years before on the theory of the firm.

If Gorton was to give a detailed account,  Holmström expected to take a birds-eye view, comparing various ideas about how the crisis had arisen in the first place, asking how each comported with Gorton’s facts. When the time for his comment came, though, Holmström departed somewhat from his plan.  He noted a paradox. In describing the nesting or interlinking of securities, structures and derivatives in the wholesale banking system, Gorton had argued that complexity was the problem: the intricate chains of debt had become so complicated that it wasn’t possible to confidently assess them. But some markets, Holmström said, actually depended on the opposite of transparency, opacity, or at least the assumption that information was symmetric, that in them nobody knew more than everybody else.  Gorton and Pennachi had observed as much themselves in 1990. After all, the markets for complex structured securities had functioned smoothly for many years – until they didn’t.  Perhaps trading in money markets was based on low information because no one had time to make detailed evaluations.  Holmströom spoke from notes; he didn’t yet have the striking example of the sealed packages of De Beers diamonds that eventually would be incorporated into his printed remarks. The panic itself was still three weeks away.  But what he said about the opposition between opacity and transparency struck sparks with Gorton. Within hours, the two were talking animatedly.

Their session was seen as largely peripheral to the rest of the conference.  The program moved on to various grandees of monetary policy: Willem Buiter, Alan Blinder; Stanley Fisher, summing up. At dinner that night, Gorton thought that attendees were living in another world. The headlines the next day sounded a cautious but hopeful note.  Things were moving swiftly now.  Gorton and Holmström agreed to remain in touch, flew home and prepared to meet their classes.  The first weekend in September, Treasury Secretary Paulson took over Fannie and Freddie. The next weekend Lehman filed for bankruptcy

.                                                     The Panic of 2008

When it finally began, the acute phase of the Panic of 2008 was easy to miss. Its consequences were, of course, unmistakable. It was if a tornado had moved through the financial industry, up-ending hundred-year-old firms, flattening supposedly safe trading places, erasing time-honored distinctions of regulation and law, throwing hundreds of thousands of persons out of homes and jobs, going so far afield as to rescue automobile companies, spilling $14 trillion of public money into financial markets in the form of investments, security purchases and loan guarantees (almost all of which were eventually paid off).

The transforming force was an old-fashioned banking panic, in which lots of people sought to take their money out of the system at the same time —  not just one bank but all banks and bank-like institutions, not just little depositors but enormous institutions, banks running on each other. The period of greatest fear and doubt didn’t last very long. It had been quelled three weeks after Lehman Brothers filed for bankruptcy, though markets remained jittery for another few months.

Yet at the time the word panic was scarcely mentioned. Why?  For one thing, hardly any living person had ever witnessed a banking panic. The fractional banking system has been evolving for hundreds of years, but the last obvious panic in the US, in 1907, had led to the creation of the Fed, designed to put an end to them. Similarly with the Bank of England: until Northern Rock, there hadn’t been a panic in Britain after 1866. Before that, occasional panics had been familiar dramatic events in market economies for several centuries, occurring every ten years or so since 1720 in London and Paris – in Britain and/or the US, in 1763, 1772, 1793, 1797, 1810, 1815, 1819, 1825, 1836, 1847, 1857,866; then, in the US, in 1873, 1882, 1893, 1907,.*  Then after 1866 and 1933, as systems of deposit insurance and emergency government lending were devised to cope with them, they seemed to go away.

* Ironically, the single most valuable source of information on the history of banking crises in 2008 was to be found in a book by  Charles P. Kindleberger, an irrepressible MIT professor, who in 1978 wrote Manias, Panics, and Crashes: A History of Financial Crises as a caution against what was the latest fad in macroeconomics, the proposition that financial markets were inherently immune to mob psychology. But Kindleberger’s literary schema was distinctly nonstandard in a field whose vocabulary depended mainly on “shocks” and “frictions,” and, though he was elected president of the American Economic Association, largely on the strength of his book, his influence operated mainly through his students, Edward Kane and Stanley Fischer, chief among them. He succeeded in injecting Hyman Minsky, of Washington University and, later, the  Levy Institute,  into the discussion of macroeconomics, as a monetary theorist with a formal model of an inherently unstable financial system who had failed to influence macroeconomics much at all. But Minsky had died in 1996, and then Kindleberger himself, at 92, in 2002. Robert Aliber, a currency expert and Kindleberger’s friend, had taken over the task of updating subsequent editions of MPC, and, by 2008, it had become a different book.

For another, the panic was invisible. Bank runs of the sort that had been a familiar feature of economic life for more than 200 years had featured long lines of depositors on the streets hoping to withdraw funds.  This panic  took place indoors. Instead of people waving savings passbooks and certificates of deposit, there were traders staring numbly at their screens.  They were trading repo, or repurchase agreements, the private money employed as collateral that sustained the wholesale banking system.  It is safe to say that few economists knew the market existed, much less understood its machinations.  The Fed had quit collecting data on it in 2006. The academic literature, which emerged quickly after the fact, centers on Securitized Banking and the Run on Repo and Haircuts , both by Gorton and Metrick, from January and August,.2009, and The Evolution of a Financial Crisis: Collapse of the Asset-Backed Commercial Paper Market, in 2012, in March 20-09, by Daniel M. Covitz ,Nellie Liang, and Gustavo Suarez, all the Federal Reserve System, and the literature that has grown up around these papers.

Moreover, with a hard-fought presidential election campaign in its climactic stages, virtually all commentators on the crisis experienced in some degree the condition known as presbyopia– blurred vision of the near-at-hand, leading to a tendency to look beyond the immediate circumstances. In this case that meant mainly finding someone or something to blame for the alarming condition whose nature was almost universally misunderstood. Everyone had a favorite villain.  Once the election was decided, the slate of culprits was revised.

Mainly, though, the panic was invisible because the very possibility of panic was ruled out by the blinders of the macroeconomists dealing with crisis, panic didn’t occur because everyone knew that government deposit insurance had rendered panics extinct, like polio or measles. The macroeconomists’ conviction was based on theory, laboriously acquired through graduate education , reinforced by experience. They knew nothing of the system of collateral banking. So panic was a diagnosis that simply failed to come to mind.

This failure to see the obvious afflicted not just one sect or another among the  macroeconomists called upon to deal with the crisis, Keynesians as well as monetarists,  theorists trained at MIT and Harvard well as those trained at  Chicago and Minnesota” all suffered from it regardless of their sect, all had acquired the same blinders early in their graduate training. This has to do with the way economics has developed since 1776. That’s why it will take ten episodes of our story to get back to 2008 (though only four to reach 1950).

So the Panic of 2008 remained invisible even to those who had first-hand experience of it. During the event itself, only central bankers and their treasury confreres had a front row seat.

.                                               Willingness to Learn

Unless you’ve personally experienced one, a panic is hard to understand.  Usually the phenomenon is physical: The rush for the exits at a soccer game

or in a fiery night club. A financial panic is viscerally powerful as any of these, perhaps even more so, at least at first, since familiar boundaries are replaced by a sense of vertigo, like a pilot losing the horizon in a fog, or airplane instruments going haywire in a storm. What’s happening can’t possibly be happening. Panic is not irrational – it’s not crazy to run for that door – but it is desperate, different from everything else in the everyday business of life.

In the wake of the crisis, it became common to explain what had happened by invoking Frank Capra’s 1946 film It’s a Wonderful Life, in which Jimmy Stewart, caught short by a bank examiner, explains the nature of fractional banking to a worried crowd.  Even Bernanke and Geithner succumbed. They would have done better with American Madness, Capra’s little-known but far grittier version of the same story, made fifteen years earlier, at a time when banking panics were still a problem.  But like Wonderful Life, American Madness is told from the perspective OF a single banker, the victim of a villain (an unscrupulous competitor in one, an embezzler in the other), caught up in an isolated event.  There are no remote causes; the system of banks and credit creation plays no part. There is no role for a central banker.

To really glimpse the essence of what central bankers are supposed to do, the film to see is Red River (1948), Howard Hawks’ classic Western, loosely based on the story of the first cattle drive north along the Chisholm Trail from pastureland in south Texas to a new railhead. in Kansas City.  Red River is mainly notable for great performances from John Wayne and

Montgomery Clift; it is memorable, too, for its depiction of a stampede, a phenomenon familiar from many other western movies. The days are hot, the trek is long. One night there are ominous signs of a developing storm. The atmosphere is thundery, the steers are restive, there is an unexpected clatter of pots and pans, and suddenly there is a stampede. Hard-riding cowhands led by the ranch owner (played by John Wayne) work together as a team. One is killed.  Eventually they succeed in turning the rampaging herd back on itself. The panic ends. Everything is quiet again. From the perspective of a central banker, the financial panic of 2008 was much more like the brush with disaster on the Chisholm Trail than the cheerful pandemonium of Bedford Falls in It’s a Wonderful Life. People with money in the banks are not cattle, but, in a panic, with hundreds of billions of dollars melting away, they may behave like them.

Fortunately, the Fed in 2008 was in the hands of a lifelong student of central banking.  Bernanke owed his appointment to Bush’s ill-considered decision to nominate White House counsel Harriet Miers to the Supreme Court.  When that nomination stalled, and Alan Greenspan’s term was up, the president needed a candidate whose nomination would gain wide assent.  Bernanke had earned the president’s trust during an emergency eight-month stint as Chairman of his Council of Economic Advisers. He chose him from a list Vice President Dick Cheney prepared that included John Taylor, of Stanford University; Martin Feldstein, of Harvard; Glenn Hubbard, of Columbia Business School; and Stephen Friedman, of Goldman Sachs, who had served two years and director of the National Economic Council.

To outward appearances, Bernanke was a Keynesian, one of those MIT PhDs who seemed ubiquitous in policy jobs around the world in the first years of the twenty-first century. He had been schooled in the traditions of New Economics, devised chiefly by Paul Samuelson, Robert Solow and James Tobin in the years after World War II. He had studied under Stanley Fischer and Rudiger Dornbusch and in the 1980s had become the foremost student in his generation of the Great Depression, beginning with his thesis paper, titled “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression,” published twenty years before. Until he took the job as chairman of the CEA, his colleagues didn’t know that he had been a registered Republican for years.

So it was an electrifying moment in 2002 when Bernanke, speaking at a party celebrating Milton Friedman’s ninetieth birthday, indicated his greatest debt as a scholar was to the Chicago economist.  Serving as a governor of the Fed at the time, Bernanke stepped out of his official role to speak past the assembled throng directly to Friedman himself: “You were right, Milton, we did it, and thanks to you, we won’t do it again.”  He was referring to Friedman’s long-standing contention that the Fed, through its failure to act as lender of last resort in the late 1920s and early ’30s, had failed to halt an escalating series of banking panics and thereby converted what might otherwise have been a garden-variety recession into a global depression lasting a decade. Bernanke, in effect, had publicly changed sides, affirming a crossing he had quietly begun with that first paper. (Those “nonmonetary effects” he identified had to do with the drying-up of credit in the ’30.) Monetarism, in effect, had won.

At the time, however, this much had seemed no more than academic and perhaps merely political, until the autumn of 2008. Then, confronted with a stupendous panic that virtually no one expected, one which only a relative handful even recognized in real time for what it was, Bernanke led the Fed in a desperate campaign against the  possibility of long-lasting financial meltdown.

.                                                          Courage to Act

Bernanke took office in February 2006 and got off to a slow start. He told Congress in March the next year,  “At this juncture, the impact of supprime lending on the broader economy and financial markets seems likely to be contained.” Then came the early-warning tremors in the summer of ’07: the Bear hedge funds, Bank Paribas, Northern Rock.  Bernanke took charge. Fed staff mobilized, especially in New York, and central bankers had a year to prepare.  A new loan-auction facility was established in December, designed to eliminate, by concealing borrowers’ identities, the stigma that was thought to have hampered  emergency lending in the 1920s and ’30s.  Swap lines were quietly created to extend Federal Reserve protection to European banks. The Treasury also drew up contingency plans, but they were not nearly as sharp. Paulson was determined to avoid spending public money.

 When the panic finally arrived, almost wholly unimagined in its extent and force, the central bank was ready – but only just.  The story of those few weeks have been told many times, from many perspectives; by Paulson, in On the Brink: Inside the Race to Sop the Collapse of the Global Financial System, in 2010; by Timothy Geithner,  his successor at the Treasury, who was president of the Federal Reserve Bank of New York during the Panic, in Stress Test: Reflections on Financial Crises, in 2014, They will be told again by Bernanke, in Courage to Act: A Memoir of a Crisis and Its Aftermath, in October. An especially good account of the cooperation among Bernanke, Mervyn King, of the Bank of England, and Jean-Claude Trichet, of the European Central Bank, is in Neil Irwin’s  The Alchemists: Three Central Bankers and a World on Fire (2013). Remember the week after  Lehman Brothers filed for bankruptcy rather than being sold? The stock market plunging sharply Trichet calling Geithner to inquire, “in French-accented combination of astonishment and derision,” if the Americans had lost their minds? Bernanke on a Wednesday morning talk show, clearly on the brink of exhaustion.  Geithner to Goldman Sachs chief executive Lloyd Blankfein later that afternoon: “Lloyd, you cannot talk to anyone outside of your firm, or anyone inside your firm, until you get that fear out of your voice.  You can replace it with anger or you can cover it up. But you must not let people hear you like that.” The desperate meetings Thursday to prepare a plan; Bernanke’s and Paulson’s trip to Capitol Hill that evening. And, finally, George W. Bush in the Rose Garden Friday morning, to ask for a massive Federal injection of funds:  “These measures will act as grease for the gears of our financial system, which are at risk of grinding to a halt.”

Over the course of the next two weeks, Bernanke, Geithner and Paulson oversaw loans to a wide range of financial institutions in order to stop a series of runs that threatened entire sectors of the financial system with collapse.  That is, they served as lender of last resort.  In this they and their  counterparts abroad were following practices that a long line of central bankers had devised.  Its basic recipes were instantiated in a book that most modern economists had never heard of, much less read.  Bernanke put it this way on his blog earlier this month:

The lender-of-last resort concept is centuries old. Walter Bagehot, the English economist, discussed the lender-of-last resort policies of the Bank of England in his famous 1873 tract Lombard Street. Bagehot famously advised that, in a panic, the central bank should lend freely, at a penalty rate, against good collateral. By providing liquidity—for example, to banks facing runs by their depositors—the central bank can help end a panic and limit the economic damage. Indeed, the Federal Reserve was founded in 1913 in large part to serve as a lender of last resort and thereby reduce the incidence of banking panics in the United States.

And so in the course of three weeks in September and October teams of central bankers and Treasury officials as capable as those cowhands in Red River prevented a depression.  George W. Bush and the legislative leaders of both parties who backed them up deserve great credit, too. But it was the trail bosses who saved the day.

 There are, however, some lingering questions about how much the crisis managers understood what they were doing in the heat of the moment.   One question has to do with what governors and presidents of regional banks were saying to each other in Federal Open Market Committee meetings. Some clearly did not recognize the panic, even in its midst.  Another question is how Bernanke and his advisers understood the situation at AIG, the giant insurance company which they took control of in exchange for a loan that eventually totaled $182 billion. (AIG-FP, which took much blame for the peril, is where Gorton had worked.) Bernanke told lawmakers in March 2009, “If there is a single episode in this entire 18 months that has made me more angry, I can’t think of one other than AIG.” The Fed’s action has been extensively litigated since then by Maurice Greenberg, AIG’s former chief executive.  We’ll hear from the judge, probably in the fall.

 A third question, perhaps the most interesting, has to do with what the authorities were telling the public.  Panic was not the way the events of September and October were described, except occasionally by economic historians, such as Richard Sylla, of New York University, and then only fleetingly.

.                                              Reticence to Teach?

For a little while, Bernanke  put the panic at the center of the Fed’s  narrative, not in speeches of his own, but in the cooperation offered The Wall Street Journal’s economics columnist. In Fed We Trust: Ben Bernanke’s War on the Great Panic (Crown, 2009), by David Wessel, was the first, and in many ways remains the best, book about the broad outlines of the crisis.  There are few nuts and bolts about the events of 2008; it seems clear the role of repo and collateral banking was not yet understood well enough to be communicated.  But the history of the Fed – its origins in the wake of the Panic of 1907, its debt to Walter Bagehot, the supposed failures of its leaders in the Great Depression, Bernanke’s promise to Milton Friedman – form the spine of the book.  I don’t mean to say that Wessel took dictation, he is one of the best in the business, But journalists are dependent to some extent on  sources, and there is evidence of the Fed’s cooperation on every page.

Bernanke himself, speaking at Jackson Hole, in August 2009, described the events of September and October as exhibiting “some features of a classic panic… a generalized run by providers of short-term funding to a set of  financial institutions, possibly resulting in the failure of one or more.”  The next year he went further, telling the Financial Crisis Inquiry Commission that, at the height of the panic, “out of the 13, 13 of the most important financial institutions in the United States, 12 were at risk of failure within a week or two.” In a speech at Princeton in September 2010, he cited Gorton and Markus Brunnermeier, of Princeton, as the principal explicators of the run-up to the panic.

In lectures at George Washington University, in 2012, he was clearer still, tracing the history of the US central bank, noting its debt to Bagehot. We’ll have to see  what more he says in in his book when it is published in October, and subsequent discussions on his blog. Like Geithner, Bernanke probably will be loyal to those with whom he shared the management of the crisis; loyal, too, to those with whom he went to school. But whatever he says won’t change the fact of the relatively reticent stance he took in the months after the crash, leaving the explaining to President Obama.

Why might Bernanke have soft-pedaled his interpretation of events? One obvious surmise is that he was intent on preserving the independence of the Fed.  The narrative of the crisis changed abruptly once the election was over. Instead of a story about 1907, known to a handful of insiders, it became an account of the 1930s and the New Deal. In the hubbub surrounding Barack Obama’s inauguration, there was nothing to be gained  by challenging the president, especially since aftershocks of the panic continued to be felt. Similarly, the emergency-lending required under the Troubled Asset Relief Program, and the magnitude of stimulus measures, meant remaining deferential to Congress, at least for as long as he Bernanke was on the job. (Bernanke fired a pretty good broadside earlier this month against legislators who want to rein in on the Fed’s emergency lending powers. That would be like shutting down the fire department to encourage fire safety, Bernanke wrote.) Then, too, there is a natural tendency on the part of leaders to project confidence, to convey the impression long after the fact that they knew all along what they were doing, when often they had operated on little more instinct and hope.

.                                                           What Have We Learned?

In any event, it’s not Bernanke’s job to do what I do here, which is to set out, from a journalist’s perspective, a little ahead of the profession itself, what economists learned from the crisis. (For a properly cautious insider’s view, see Credit, Financial Stability, and the Macroeconomy, by Alan Taylor, of the University of California at Davis, forthcoming in the Annual Review of Economics.) It is not from Kindleberger and Minsky that we now understand what happened in 2008, and what might better prevent it from happening again; nor, for that matter, from any of the rest of the work on credit and financial stability that was done before the Panic of 2008.

Gorton, a relatively unknown historian of banking who made a name for himself in financial markets, and Holmström, the low-key Paul Samuelson Professor of Economics at MIT, are an unlikely a pair. Working together for a few years, they reasoned out a distinction that now appears to be absolutely fundamental – that debt, meaning money and money in the bank and IOUs, should optimally be opaque, while the price of virtually everything that money can buy should be transparent as possible. To understand how they did it requires some explaining. That Gorton had spent a dozen years advising on deals in a hotbed of innovative finance had something to do with it; so did the fact that Holmström had begun his career thirty years before as a corporate planner. Each man experienced business practice from the inside.

More important, both men were highly skilled practitioners of economics at its cutting edge. They possessed somewhat different talents, but they shared a sense of what might constitute a genuinely satisfying explanation. They kept at their task until they felt they had one. From a distance of seven years, it seems possible , even likely, that technical economics rose to the occasion in 2008 – not the improvisational tradition known as macroeconomics, but rather bedrock microeconomic understanding on which the economics of information has been constructed.  On the strength of what they had learned about the Great Depression of the 1930s, its practitioners, led by Bernanke, furnished advice that  prevented it from happening again.  In the course of the second episode, Gorton and Holmström and the many other contributors to financial macro  discovered lessons that, in time, may prevent a third.

To understand how this happened means knowing something about how economics came to be the way it is today.  The best way is to start at the beginning. The story here is structured as a history of central banking, with a concomitant interest in economic development and growth.  By the time you finish the next chapter, you’ll understand why.

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