Out of the Shadows

It was a late-night email in February 2010 that brought me into the story: a boilerplate circular from an author about his otherwise unheralded book, Except for the title, Slapped by the Invisible Hand: The Panic of 2007 (Oxford, 2009) looked unpromising: a volume in an obscure series, aggressively priced ($34.95) – probably one more finance professor with no real idea what he was writing about. The author was Gary Gorton.

On the other hand, the book had great blurbs. Robert Lucas, of the University of Chicago, wrote that it offered “the most coherent and convincing account” of the crisis that he had seen.  Peter Fisher, formerly of the Federal Reserve Bank of New York and the Treasury Department, called it “indispensable.” H. Rodgin Cohen, of Sullivan and Cromwell, who had represented many of the institutions caught in the crisis, recommended it; so did former Sen. Bill Bradley, then a potential Treasury Secretary. I ordered a copy from Amazon – no discount.

Slapped turned out to be as good as its blurbs.  Indeed, it is still the best account of what actually happened – all the more remarkable because it was written in real time, on the eve of the panic and a few months after.  It consists mainly of the two papers Gorton had written for Federal Reserve banks to explain what had happened – the first for  the Jackson Hole conference, in 2008; the second, for a Federal Reserve Bank of Atlanta conference the following spring, about the events of September and October 2008.  Included, too, was a seemingly prescient paper about the emerging shadow-banking system written fifteen years before, “Bank Regulation when ‘Banks’ and ‘Banking’ are not the Same.”

Gorton had a remarkable standpoint. Not only was he a prominent historian of US banking. He had consulted to AIG-FP, the unit at the very center of the crisis, building models of credit derivatives and commodity future for more than a decade before quitting at the end of 2008 .  His explanations had the ring of truth.* A few months before, I had felt strongly enough about the inadequacy of a reply concocted by experts to Queen Elizabeth’s  question about the crisis that had nearly wrecked her realm to send a copy of Manics, Panics and Crashes: A History of Financial Crises (Wiley, 2000) to Buckingham Palace as “A Low-Tech Device for Horizon-Scanning.” Slapped was Kindleberger brought up to date.

* I wasn’t the only one to be calmed by a historian. After Mary T. Rodgers heard Richard Sylla, of New York University’s Stern School of Business, saying on PBS’ The NewsHour of September 19, 2008, that panics, though largely forgotten in recent years, had once been a familiar feature of markets, she quit Merrill Lynch and retooled as an economic historian herself.

Gorton had even won the best-metaphor contest, hands down.  In the thundery summer before the panic, when soon-to-be Treasury Secretary Timothy Geithner had posed the challenge to his staff, the entries pictured wheels coming off, rivets popping, and so on. After the panic occurred, Gorton compared fear of toxic assets to the periodic scares that happened when beef became infected E coli bacteria. No one knew the particular source of the danger, so people stopped buying hamburger altogether. Others, may have used the analogy orally, but Gorton was first to write it down. In the spring of 2009, former Treasury Secretary Paul O’Neill had put it this way to an interviewer in The New York Times Magazine, “If you have 10 bottles of water, and one bottle had poison in it, and you didn’t know which one, you probably wouldn’t drink out of any of the 10 bottles; that’s basically what we’ve got there.” But neither of these formulations had much currency at the time.

I was working on another project, a history of game theory and behavioral economics. I put it aside for a day  and drove down to New Haven to see Gorton. He turned out to have an unusual background:  he had been a Marxist economist, a student of Chinese literature, union organizer, cab driver, graduate student, prison tutor, central bank economist, historian, high-paid arbitrageur, would-be entrepreneur and theorist. He was still much-shaken by his experience at AIG-FP; upset, too, at his inability to deflect, even slightly, the course of events, despite his inside knowledge.  I wrote up the trip in EP, in April 2010, in Constructing the Narrative.

A month or so later, I met with Bengt Holmström at MIT.  He had been the discussant of Gorton’s paper at Jackson Hole.  For the first thirty minutes, he fumed about Slapped. He was especially angry that Gorton had split the long paper in two, creating a hinge not present at the meeting, which, Holmström felt, took advantage of the insight he had furnished without acknowledging its source.

Yet as he turned to describing the research partnership into which he had entered with Gorton –a paper to describe in technical detail the implications of their conversation — Holmström’s anger subsided and gradually yielded to admiration. The more he talked, the more I was struck by the extraordinary precision of his speech. It was cleared the pair had long since overcome whatever discomfiture had existed. By the last thirty minutes of our conversation Gorton had become not only Holmström’s colleague but his friend. I heard for the first time a sentiment voiced many times again at the end of a disquisition by one or the other on the shortcomings of his counterpart: “Yet where would I be without him?”

Thereafter I had a pretty good window on economics as it was done, by two very different but equally talented economists. I read what they published, talked to them when I could. At one point, Gorton described the moment when he realized that he would spend the rest of his career on the implications of the crisis.  Not me. I am still no scholar of the Panic of 2007-08, much less an specialist in banking journalism, and I can’t wait to get back to covering the news. But I had been drawn into a remarkable story.

.                                                    The Priest and the Bishop

When Gorton and Holmström took the stage at Jackson Hole, they had already been speaking at regular intervals by telephone for several months, out of mutual determination to do a good job: Gorton to describe the workings of what he then called the securitized banking system; Holmström to take a birds-eye view of the looming crisis.  It is impossible to know exactly what was said from the rostrum that day; their remarks were published only after the panics had occurred. Neither man had arrived at the metaphor that would most vividly convey his ideas.

What is clear is that something happened in the conversation afterwards. Years later Gorton sought to describe it:  “The ideas… that debt is designed to be ‘secretless” or “information-insensitive” have their origins in Holmstrom [comments] and are further developed in Holmström’s [presidential address]. [A paper by] Dang Gorton and Homström (2011) also develops this idea and argues that debt is the best instrument for trading purposes, providing liquidity.”  The key word here is designed; the design of economic “mechanisms” of every conceivable sort had acquired new significance in economics since the 1970s.

Gorton had described in detail  the panic of August 2007 – not the “quantquake” of the same month, which involved several hedge funds selling stocks at once, having discovered they were all pursuing the same strategy, but the early stages of the subprime panic. He described in detail the design of subprime mortgages, the construction of mortgage-backed securities, the role of structured investment vehicles, the advent of the ABX index of house prices, and the significance of its fall.  He explained the run on the SIVs, the collateral calls, the frantic and unsuccessful attempts to identify which subprime assets were “toxic,” the ultimate outcome being a situation in which no one would trade with anyone who wanted  to trade with them. This was, of course, the story of “Lemons,” the famous 1970 paper by George Akerlof, the first to argue that asymmetric  information could ruin the market for used cars  No one used those terms in August 2008, because the ’07 panic has been invisible to all but a relative handful of hedge-fund traders in highly-specialized short-term money markets.  That morning Gorton had argued the standard view, that complexity and loss of information had been the problem.

Holmström’s idea – and almost as quickly, it became Gorton’s, too – was just the reverse – that suppressing information had been the point of the system; that debt was designed in such a way that, ordinarily, there would be no incentive to look under the hood.  As far back as 1990, Gorton and George Pennacchi had argued that because debt was ordinarily an information-insensitive security, there was no need to worry about whether one’s trading partner may be taking advantage of better information was a desirable feature. That was almost but not quite the point,  in the context of the Panic of 2007, when Holmstrom took the argument the next step of the way.  Supposed the system was supposed to be that way?  What happened when the incentives changed?

Both economists returned home and witnessed the growing turmoil. After Lehman, September 15, with no word from Holmström, Gorton had paired up with Tri Vi Dang a young mathematical economist teaching at Columbia to write up the moral OF their exchange.  He invited Holmström to join them, in hopes of properly grounding in theory the considerations they had jointly produced. The professional distance between the economic historian and the theorist was considerable, between say, a bishop and a  provincial parish priest. Holmström agreed to join in. Dang, Gorton became Dang Gorton Holmström, or DGH.

.                                                            Spreading the word

With drums beating and roofs burning, Gorton and Holmström went to work. Gorton produced his first working paper on the most recent events on October 1, arguing that the panic of 2007-08 was a single long seamless event, and updated it ten days later, after the G-20 communique. “None of the various layers of intertwined securities, off-balance sheet vehicles (and their liabilities), or derivatives are traded in markets that resemble those that economists tend to focus on, namely, the secondary market for equities,” he wrote. “Nor does the banking system that I will describe look very much like what is taught in courses on ‘banking’.”

Holmström worked on the printed version of his Jackson Hole discussion and had in mind a clear example of the virtue of opacity by October 9, when he spoke (at 35:15 on the video) to an MIT panel on the crisis. Here’s the way Holmström put it in the printed volume of the Jackson Hole proceedings:

[C]onsider the way de Beers sells wholesale diamonds. They place the diamonds in packets that buyers are forbidden to explore. The packets are sold on their gross attributes on a take-it-or-leave-it basis. If buyers were allowed to look into the packets first to a get a better estimate of their value, packets left behind would become tainted.  Inspection would slow down trade and might even prevent trading entirely. Placing diamonds in packets eliminates adverse selection among buyers. Similar problems between de Beers and the buyers are, in turn, eliminated by de Beers’ concern for its reputation, supported by its monopoly rents and by repeat buying. …[F]ar from being a problem, lack of transparency enhances market liquidity.

Gorton and Holmström joined the Liquidity Working Group of the Federal Reserve Bank of New York, the Fed’s emergency brain trust. Together they wrote a series of memos to the Treasury, putting their shoulders to the effort to turn around the  TARP authority from buying assets to making loans (i.e. injecting capital into the banking system). “Everyone was learning on the job,” remembered Gorton. In the next few weeks, Gorton and his colleague Andrew Metrick, a Yale School of Management colleague who was rapidly becoming a co-author, gave seminar talks to various departments, explaining to economists what had happened. So did Holmström. The Atlanta Fed asked Gorton to write a description of the panic for a May meeting on Jekyll Island, the hideaway Georgia resort where plans for the Fed had been drawn up a century before.

In April, the first iteration of DGH appeared, not ready to be declared a working paper: “Ignorance and the Optimality of Debt for the Provision of Liquidity.” It was, Gorton and Holmström authors agree, all but unintelligible. The next month, Gorton presented a new paper on the panic at Jekyll  Island, the essay one that would become the centerpiece of Slapped.  Meanwhile, Holmstrom had discussed “The Credit Rating Crisis,” a paper by Efraim Benmelech and Jennifer Dlugosz  at the Macroeconomics Annual 2009 conference of the National Bureau of Economics Research. The facts are great, he tells the meeting, but the conventional interpretation of them may be misplaced. He described the repo markets this way:.

These are high-volume, high-velocity markets in which hundreds of millions of dollars of credit may be extended in a single trade on short notice.  For example, in 2008 securities firms had to roll over 25 percent of their funding every night, much of it more or less automatically, but still requiring daily confirmation.   In such markets there is little time for background checks , and most of the trading is contingent on trust that counterparty risk is minimal.  As the saying goes, if a banker has to prove his creditworthiness, he has already lost it.  The market grinds to a halt if background checks are needed….

[M]uch of what is commonly seen as a cause of the crisis – especially the opacity of structured financial products, the coarse and inaccurate (in retrospect) assessments of credit risk, and the seeming indifference to the true value of the underlying collateral – may be rational, even essential, for liquidity providing markets.

Alas, I skipped that session of the conference session. I wrote up the one before instead, John Geanakoplos, of Yale University, on leverage cycles. By seizing on one skein of developments here, I am, of course, leaving out many others. Markus Brunnermeier, of Princeton University, wrote an account of events in Journal of Economic PerspectivesDeciphering the Liquidity and Credit Crunch of 2007-2008.  Editor Andrei Shleifer, himself involved in financial markets and author models of them,, had asked for the paper. When the time came, in a speech on “The Implications of the Financial Crisis for Economics,” at Princeton University, in September 2010, Bernanke cited both Gorton and Brunnermeier.

.                                                                     Gorton’s path

However much Gorton and Holmstrom differed in some respects, they resembled each other each closely in important dimensions. They confessed to the same faith in the methods of present-day economics; they were both experienced in business and financial practice and respectful of it; and, perhaps most important, they shared the same stringent standards of what constituted a satisfying explanation.  They led cosmopolitan lives.  Otherwise, they proceeded along separate tracks.

Gorton wrote a steady stream of papers. He paired up with Andrew Metrick, the Harvard-trained economist who was instrumental in binging Gorton to Yale from the University of Pennsylvania’s Wharton School. Together they wrote a series of papers explaining the plumbing of the new banking system: securitization, repo, haircuts, regulation, and the mechanics of the panic. With Markus Brunnermeier and Arvind Krishnamurthy, Gorton wrote “Risk Topography,” a paper for the 201l NBER Macreconomics Annual, , which described an attempt to identify new measures of systemic risk which, after several field trips to major institutions, failed to produce the accounting system that had been the project’s  ambitious goal.

Gorton’s book containing three papers, Slapped, appeared in March 2010. It attracted little attention. About the same time Gorton prepared a question-and-answer crib sheet for the Congressional commission investigating the causes of the crisis and gave testimony that shaped the report. (Dissension among members limited its influence.)  With Metrick, he wrote a paper for the Brookings Panel on Economic Activity advocating the charter of a new sort of bank, one whose business would be limited to buying, packaging and reselling securitized debt. Although the proposal was politely received, nothing came of it. Gorton gave up public advocacy. He concentrated on a preparing a paper to accompany the talk he  had been asked to give in May 2011 to the Federal Open Market Committee, the policy-making body of the Fed.

Interest in Gorton’s arguments was growing in the profession in 2010, but it hadn’t reached the stage of familiarity. The Region is a glossy monthly publication of the Federal Reserve Bank of Minneapolis that for more than  twenty years has published lengthy interviews with leading economists, thereby providing a pointillist portrait of the profession as seen from the capital of freshwater economics.  When Gorton appeared on its cover, in December 2010, the accompanying article began with a quote from a hometown favorite, economist Randall Wright, of the University of Wisconsin: “I have no idea what Gary said just now, but I know it’s really, really important, so I’m going to sit down and study this until I get it.” Readers may well have the same reaction, the editor warned.  He gave the interview extra space.

.                                                                 Holmström’s Path

Holmström spent the spring of 2010 visiting Stanford, seeking to understand the repo market. Some theorists drive as fast as they can to an interesting new problem.  “I am a walker,” he says.

In July 2010, Eric Maskin, of Harvard University, a thought leader among recent economics Nobel laureates, took to the popular Five Books section of The Browser, to argue against the view that economics had been caught napping by the panic. In words that Maskin probably never spoke, the article began, “Contrary to popular perception, economic theory did a very good job of predicting the financial crisis, it’s just that no one was paying any attention.”

Maskin’s list provided an excellent glimpse of the way economic theory unfolds at its highest level – how its structures are constructed and carefully fit together – or not – in such a way as to revealed unexplored places in the argument. Thus, Maskin wrote, Douglas Diamond and Philip Dybvig, in Bank Runs, Deposit Insurance , and  Liquidity, in 1983, made the case for offering government bank insurance.  It was “certainly a good starting point, and a good deal  of the subsequent work on banks and on liquidity follows in their footsteps. But they don’t take account of moral hazard” – the possibility that privately-taken actions will affect the probable outcome.

Next came Private and Public Supply of Liquidity, in 1998, by Tirole and Holmström. According to Maskin, their paper made two points important in the  ongoing conversation: that bank capital act as the “skin in the game” necessary to insure that bank proprietors keep a close watch to insure that their loans will be repaid; and an argument for government’s role as lender of last resort in the event of a systemic run – part of the practice known as central banking. Holmstrom and Tirole published an expanded version as Inside and Outside Liquidity  (MIT, 2011). Meanwhile, The Prudential Regulation of Banks (MIT, 1994), a book by Mathias Dewatripont and Tirole, came next on Maskin’s list: a survey of the incentives in banking showing how and where it makes sense to regulate, using mainly capital asset requirements.  .

Finally there were dynamics. How might a sudden loss of liquidity occur?  In 1997, in Credit Cycles, Nobu Kiyotaki and John Moore, identified the possibility that  fire sales of the collateral borrowers pledged to lenders – resources, real estate, family jewels, whatever – might produce a downward spiral in asset values.  Ten years later, in Leverage Cycles and the Anxious Economy, Ana Fostel and John Geanakoplos argued that a tendency to lever-lower cash down-payments might produce an upward spiral which even a small piece of bad news could turn into a crash. Perhaps a governmental role for limiting leverage was the answer.

Such were Maskin’s five key readings in crisis economics.  “I think most of the pieces for understanding the current financial mess were in place well before the crisis occurred,” he told The Browser. “If only they hadn’t been ignored.  We’re not going to eliminate financial crises altogether, but we can certainly do a better job of preventing and containing them.”

In January 2012, Holmström delivered his presidential address to  the Econometric Society – a daunting challenge to those who over the years have enjoyed the privilege.  He gave a oral  account of his thinking to a jam-packed hall in a talk titled “When Ignorance Is Bliss.” In EP, in  Continuing Education, I described the scene. Holmström’s talk was compelling; but instead of a model, he illustrated his argument with a series of slides showing various parts of the argument of DGH – he and Gorton and Dang were still working on the proofs. It didn’t matter; Holmström had plenty of time.  He still had to turn his informal talk into a proper paper too be published in Econometrica, journal of the society, as his presidential address.

In March, the first edition of an expansive new prize created by the Bank of France and the Toulouse School of Economics for Monetary Economics and Finance was awarded to Holmström “for his analysis of liquidity under asymmetric information.” His collaborator Gorton and his student Krishnamurthy joined him for the ceremonies. The hope in these quarters was, of course, that DGH, or some off-shoot that would emerge from it, or perhaps Holmström’s presidential address, eventually would be added to the kind of list that Maskin made.

.                                                                                Repo!

If I had time, I could have written a good journalistic account of the rise of repo, the $20 trillion or so global market at the heart of the panic.  I would have begun with the bankruptcies of two small specialized brokerages, Drysdale Government Securities and Lombard Wall, in 1982. The ambiguity that their failure revealed resulted in the carve-out from the bankruptcy laws of  the collateral that was usually involved in such deals.  That was all that was required for the explosive development of a vast a collateral-based insurance system for short-term “deposits” of sums far too large to be protected by the Federal Deposit Insurance Corp. But I don’t have time, not now, anyway.

So in the interest of clarity, I will quote extensively from one of Gorton’s own discussions, in that 2010 interview in The Region. Douglas Clement, editor of the magazine, conducted the conversation.  The full interview is here.

GORTON: In the last 30 or 50 years, there have been a number of fundamental changes in our economy.  One of the most fundamental of these has been the rise of institutional investing. The amount of money under management of institutional investors has just been exponentially increasing.

These include pension funds, mutual funds, large money managers. And these institutions basically have a need for a checking account, if you will. So if you’re a large institutional money manager, you may need a place to put $200 million, and you want it to earn interest and to be safe and accessible. That led to the metamorphosis of a very old security: the sale and repurchase (or “repo”) market. Like a check, repo had been around for perhaps 100 years, but it was never very large.

CLEMENT: This is in the early 1980s?

GORTON: Well, the early ’80s are the beginning point of a number of developments that are going to come together. We don’t have any data on repo except for a small subset of firms, so we can’t document many of the things we’re interested in knowing. I’ll come back to this problem later, perhaps: the measurement problem in macroeconomics generally.

But these firms basically would like to have a checking account, and a repo provides that in the following sense. Let’s just start with a regular bank. If you put your money in a checking account in a bank, they pay you, say, 3 percent; they take your money and lend it out at 6 percent. They make the spread. Banking is a spread business.

Repo works similarly. You take your $200 million to the bank, to Lehman Brothers, say. You deposit it, so to speak, overnight so you can have access to it the next morning if you want to. They pay you 3 percent. And you want it to be safe, so they give you a bond as collateral. But Lehman earns the interest on the bond, say, 6 percent. And the bond is going to turn out often to be linked to bank loans.

CLEMENT: And there’s also a “haircut,” true?

GORTON: There may be a haircut. If you deposit $100 million and they give you bonds worth $100 million, there’s no haircut. If you deposit $90 million and they give you bonds worth $100 million, then there’s a 10 percent haircut.

CLEMENT: Just to be clear, they don’t deposit those funds in a checking account because …

GORTON: Right, because the Federal Deposit Insurance Corporation limit is too low, just $250,000, and these deposits are in the tens or hundreds of millions.

There are competitors for repo that these firms consider and use, but again we don’t know the relative sizes of these. I think now we have a good idea of what repo was just before the crisis.

But repo—the transaction I just described—has other similarities to the checking account story. If you put a dollar in your checking account and the bank has to keep 10 percent of it on reserve, they lend out 90 cents. Somebody deposits that 90 cents, the bank can lend out 81 cents (because of the 10 percent reserve requirement) and so on. So you end up creating $10 of checking accounts for $1 of demand deposits, assuming there’s a demand for loans. Now, that money multiplier process is very important because it means that the amount of endogenously created private bank money in checking accounts is 10 times the size of the collateral, so to speak, of $1 of government money. So, in a traditional banking panic, if everybody wants their $10 back, there’s only $1. And that’s the problem.

CLEMENT: The Jimmy Stewart problem.

GORTON: Right, the Jimmy Stewart problem. And that can happen in repo as well because if you’re Lehman and I’m the depositor, and you give me a bond as collateral, I can use that bond somewhere else. So there is a similar money multiplier process.

CLEMENT” That’s “rehypothecation,” right? One of my favorite new words.

GORTON: Yes, it’s become very popular lately [laughs]. So, if shadow banking refers to the growth of this type of money—and it’s not controversial to say it’s money; it was counted in M3—but in order for this to grow, you have to have the collateral, and collateral, of course, like in the pre-Civil War era, can turn out to be risky bonds.

The reason for this is that there aren’t enough high-quality bonds. Prior to the crisis, there were not enough Treasuries. Many Treasuries are owned by foreigners and are not available to be used in repo. And collateral is also demanded for posting in derivatives transactions, and for clearing and settlement. The most common way of dealing with counterparty risk is to ask for collateral. So the demand for collateral is pervasive. For repo to grow, you needed to have more collateral….

In summary, I would describe shadow banking as the rise to a significant extent of a very old form of bank money called repo, which largely uses securitized product as collateral and meets the needs of institutional investors, states and municipalities, nonfinancial firms for a short-term, safe banking product.

CLEMENT: So, it’s a valuable innovation.

GORTON: Exactly. It’s a valuable innovation.

Meanwhile, Gorton’s work with Metrick had produced a surprising finding:  while total assets in the United States had grown dramatically in the past sixty years – from around four times GDP in 1952 to around ten times GDP in 2010 – the percentage of all assets that could be considered “safe” had remained very stable over time, at a little over thirty percent of GDP.

What’s considered a safe asset? It’s what we ordinarily mean when we speak of  “money in the bank. ” Government debt is safe, of course, and many kinds of private financial debt – not just bank deposits, but money market mutual funds, commercial paper, interbank loans, repurchase agreements (repo), municipal bonds, securitized debt, and high-grade financial sector corporate debt.

Why that relationship should have remained so stable, given decades of shifting trends of government and private sector finance, was a mystery, Gorton, Metrick, and Stefan Lewellen wrote in The Safe Asset Share in the American Economic Review in 2012, but a promising one to investigate.  “The traditional concepts of a ‘bank’ and of ‘money’ are no longer adequate to describe the world in which we live,” they wrote. Because a shortages of safe assets were thought to have been an important contributor to the recent crisis, interest in their manufacture became widespread.

Misunderstanding Financial Crises: Why We Don’t See Them Coming (Oxford, 2012), the expanded version of Gorton’s Federal Open Market Committee talk, appeared in November, to respectful reviews. Nobody seemed to care much any longer about the crisis. A parallel he drew between Franklin Roosevelt’s first fireside chat, in which the president calmly explained why he had declared a “bank holiday” to stem the banking panic, and the relative lack of narrative in the first few months of the Obama administration, was scarcely noticed at all. Obama had been re-elected.  The analogy of toxic assets to E. coli still hadn’t taken root.

.                                                     “The Head Has Disappeared!”

Holmström and Gorton continued to work on the formulations of DGH. They talked on Skype, they travelled back and forth occasionally; Dang joined them sometimes, sometimes not. The two economist shared an admiration for a slim book by the American writer James Lord.  A Giacometti Portrait (Fararr Straus, 1965) is an account of sitting for a portait.by Alberto Giacometti over eighteen sessions in Paris in 1964.  Giacometti was famous mainly as a sculptor; but the young American, who eventually would write a biography of the artist, knew him to be a brilliant painter as well. In barely more than a hundred pages, Lord managed to convey a great deal about the baffling uncertainty of the process of making art, by recording what the painter did, and didn’t do,  and said  as he painted.

Periodically Giacometti would efface the head he had painted at the center of the portrait and start again. Each time he explained that “the head has disappeared,” meaning from what his painter’s eye could see. Lord attempted to keep a photographic diary of the painting’s progress but failed, lacking in skill with his camera.  The climax comes when Giacometti finished painting and expressed disappointment. “Well, we’ve gone far.  We could have gone futher still, but we have gone far. It is only the beginning of what it could be. But that’s something, anyway.” He continued:

To make really lifelike is impossible, and the more you struggle to make it lifelike, the less lifelike it becomes.  But since a work of art is an illusion anyway, if you heighten the illusory quality, then you come closer to the effect of life.

“But how do you do that?” Lord asked. “That’s the whole drama,” replied the painter.

Gorton and Holmström would talk in similar terms about their own attempts to capture the role of debt in a modern economy in a series of highly abstract mathematical statements the role of debt in a modern economy.  “The head has disappeared!” became a standing joke.

Between times, Gorton had become something of a one-man chorus, commenting on the crisis for the instruction of a broader audience among economists. In January 2012 he and Metrick surveyed the recent empirical literature in Getting Up to Speed: A One-Weekend Reader’s Guide for the Journal of Economic Literature. For the joint celebration of the hundredth anniversary of the founding of the Fed conducted by the Fed and the NBER, he wrote, with Metrick,  The Federal Reserve and Panic Prevention: The Roles of Financial Regulation and Lender of Last Resort, subsequently published in the Journal of Economic Perspectives. (Julio Rotemberg wrote on the role of penitence in the Fed’s conduct of monetary policy.)   For the Journal of Economic Literature, Gorton reviewed The Big Short, by Michael Lewis, and The Greatest Trade Ever, by Gregory Zuckerman, in 2011; and Stress Test, by Timothy Geithner, in 2014. He collected his papers on banking. With Metrick, he started an annual Yale summer school for central bankers which met last month for the second time.

Gorton and Holmström completed the proofs of DGH, or “debt-on-debt,” as it had become known, Gorton began a collaboration with a colleague, Guillermo Ordoñez, Collateral Crises, an alternative to the leverage account, appeared. Holmström and Dang then joined a second Gorton- Ordoñez project, Banks As Secret Keepers, which took a close look at the role of banks, adding an element of flavor of the theory of mechanism design to the contract theory of DGH, or at least so Gorton said. Holmström worked on his presidential address. “He needs a deadline, Gorton said.

He got one when he agreed to give a paper at the annual conference of the Bank for International Settlements, in Lucerne, Switzerland, in June 2014.  The BIS, a holdover from the days of the League of Nation – it was chartered to oversee reparations from after World War I – evolved after World War II into the nerve center of global central banking, a mysterious, glamourous, and superbly well-informed entity half-concealed in Basel, Switzerland, far away from the easier-to- find International Monetary Fund, in Washington, D.C.  Research directors William White and Stephen Cecchetti artfully steered it through the crisis; Hyung Song Shin took over in May 2014.

.                                                             Holmström at the BIS

The paper Holmström produced, Understanding the Role of Debt in the Financial System, was, at last, the essay he would submit to Econometrica as his presidential address. The abstract tells the story pretty well:

Money markets are fundamentally different from stock markets. Stock markets are about price discovery for the purpose of allocating risk efficiently. Money markets are about obviating the need for price discovery using over-collateralized debt to reduce the cost of lending. Yet, attempts to reform credit markets in the wake of the recent financial crisis often draw on insights grounded in our understanding of stock markets. This can be very misleading. The paper presents a perspective on the logic of credit markets and the structure of debt contracts that highlights the information insensitivity of debt. This perspective explains among other things why opacity often enhances liquidity in credit markets and therefore why all financial panics involve debt. These basic insights into the nature of debt and credit markets are simple but important for thinking about policies on transparency, on capital buffers and other regulatory issues concerning banking and money markets.

“Understanding the Role of Debt” is a mere 29 pages. It contains no formal model  except as “Banks as Secret Keepers” and  DGH (2012) are cited, the latter now listed as “Ignorance, Debt and the Financial Crisis,” mimeo, Yale University. Yet Holmström’s paper almost immediately was recognized as work of major significance.

The paper contained the diagram that Holmström had introduced at the NBER Macroeconomics Annual conference in April 2009 – a “hockey stick” depicting the transition from a time in which the value of debt is take is taken for granted – “no questions asked – to a time  in which enterprising investors decide to invest in looking behind the veil.

It contained, too, a table enumerating the characteristics of “two entirely different systems,” of stock markets and debt markets, that seems likely to become a staple feature of principles textbooks in the future.

The paper offered a terse account of panics as information events, the “ill consequence of debt and opacity.”

It contained the by-now familiar sealed bag of diamonds. But it offered a powerful new illustration of collateralized debt, too.  The pawn shop, wrote Holmström, is one of the oldest providers of liquidity in the financial world, as repo is one of the newest. Pawn shops date back at least to the Tang Dynasty (650 CE).

The borrower brings to the pawn shop items against which a loan is extended. The pawn shop keeps the items in custody for a relatively short (negotiable) term, say one month, during which the borrower can get back the item in return for repayment of the loan. It sounds simple, but it is a beautiful solution to a complex problem.

The beauty lies in the fact that collateralized lending obviates the need to discover the exact price of the collateral. A person that runs into a liquidity problem can sell an asset, a watch say, but selling the watch requires that an agreeable price be established. There may be a market for used watches, but it is unlikely to be very efficient at price discovery. If the watch is unique the price would have to be negotiated in bilateral bargaining. It may be costly to come to an agreement. And the highest value user of the watch could be the owner, so a sale will imply a potentially large liquidation loss or there may be no trade.

The dilemma is solved by pawning the watch. In that case the parties do not

have to agree on the value of the watch. The right to redeem the watch at the same price at a later date, hopefully when the borrower’s liquidity problem has passed, reduces bargaining costs. The information needed to reach an agreement on the price of the watch (the loan) is relatively small. The broker will offer a price that entails a big enough haircut so that she can recover her money by selling the watch if the owner does not come to redeem it. A safe lower bound is all that is needed.

There is no price discovery in the sense that the price is close to what the watch would fetch in an arms-length bargaining process. Today’s repo markets, which play such a prominent role in shadow banking and also in the crisis, are close cousins of pawn brokering with similar risks for the parties involved. In a repo the buyer of the asset (the lender) bears the risk that the seller (the borrower) will not have the money to repurchase the asset and just like the pawnbroker, has to sell the asset in the market instead. The seller bears the risk that the buyer of the asset may have rehypothecated (reused) the posted collateral and cannot deliver it back on the termination date.

In today’s repo markets repo fails on both sides are relatively rare, but they happen, especially in times of stressed markets. Interestingly, the risk that a pawnbroker may sell or lose the pawn was a big issue in ancient times and could explain why the Chinese pawnbrokers were Buddhist monks. Their morality served to alleviate fears of absconding with the collateral.

There is one significant functional difference between pawning and repo. In pawning the initiative comes from the borrower who has a need for liquidity. In repo the motive is often the opposite: someone with money wants to park it safely by buying an asset in a repo (or reverse repo as it is called from the lender’s perspective). This feature played a key role in the rapid rise of shadow banking that preceded the crisis…

And so on to the savings glut.

For many years, commentators have been searching for a name for the system that nearly broke down in 2008. It was the “shadow” banking system or the “new” banking system or the “parallel” banking system or the “securitized”  banking system.  It is too early to say with any confidence what common usage will emerge.  My hunch is that it will turn out to be the “collateralized” banking system that emerged when it became clear that government insurance was no longer enough to render safe the financial assets, mostly debt, on which trade depended.  That is a very different story of what happened from “moral hazard” and “regulatory arbitrage.”

Recently Holmström wrote in an email, in one more attempt to restrain my enthusiasm.  Of a recent conversation he said,

I hope I didn’t deflate your punch line – nor inflate it initially. I still think it [the story covered by the BIS paper] is the most (and perhaps the only) coherent, relatively comprehensive narrative. Many parts have been enriched and amended by important work of others. But it remains a reasonable and early sketch of the whole elephant. And just as importantly, it went in a very different direction than the early knee-jerk reactions. It saw the virtue of information insensitivity at a time when people only saw it as the culprit, because the tail risk materialized.

As for DGH: at the time of the presidential address we had a complete set of theorems correctly proved. The delay has been caused (apart from leaving the project idle for long periods) by a desire to improve on the assumptions and formulations. We have run into a lot of dead-ends and continued dissatisfaction. In the process the paper and our understanding of it has improved greatly. The focus of the paper has shifted in edifying ways, the theorems have become more general and the proofs simpler. This kind of conversational journey with models is the reason we do theory. The better the ideas, the longer it is worth looking for new insights. We have now what we think is the best formulation we will come up with along with proofs. And yet I wish it would be a bit better.

.                                                        Gorton and GB3

Gorton, meanwhile, was busy, as usual.  To the BIS research conference in 2015, he contributed, with Tyler Muir, of Yale University, Mobile and Immobile Collateral, a criticism of the BIS’s response to the crisis – its  “liquidity coverage ratio” – which requires a working knowledge of the panics of the US national banking era – the years between the Civil War and the establishment of the Fed — to understand.  He revisited, with Geetesh Bhardwaj, of SummerHaven Investment Management, and Geert Rouwenhorst, of Yale University, what remains his most famous paper: Facts and Fantasies about Commodity Prices Ten Years Later – a venture that needn’t detain us here, though commodity traders certainly find it fascinating.

Again with Ordoñez, Gorton began a project to seek a better definition of business cycles than either the NBER approach of  thick description or the deviations-from-trend approach of Robert Lucas and the freshwater school.  Good Booms, Bad Booms argues that, while all booms start with an increase in Total Factor Productivity and Labor Productivity, such advances fall off rapidly in bad booms. When growth rates fall off quickly, there is a crisis. They postulate an “information cycle”: the transit of the financial system from a ”symmetric information” regime to a ”symmetric ignorance” regime. The growth of symmetric ignorance endogenously generates a growth in the incentives to generate information and then a decline in the chances that ignorance is sustainable. Effectively the boom plants the seeds for its own destruction.

And, of course, with Holmström, he is still working to complete the paper to accompany DGH.

.                                                                            xxx

Gorton and Holmström are not supermen.  They are members of a dense scientific community – many overlapping communities, in fact.  But by throwing in together, combining their disparate skills and background knowledge, and then working patiently towards an elusive goal over a long period of time, they accomplished something that neither could have done alone. They contributed a preliminary understanding of the circumstances surrounding two Great Depressions, one that happened, another that didn’t, an understanding  that otherwise might have taken others in the profession many more years to reach. They kept at it until they were done, or nearly so.  Notwithstanding such warts as they possess, they have proved to be unusually good  citizens of the republic of economic science.

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