Slapped by the Invisible Hand: The Panic of 2007

Banking panics: "I never dreamed that I would live through one," writes Gary Gorton on the first page of this book. Until 2007, they were something that happened in history, and certainly not in the modern developed world.

Banking provides the lifeblood of the economy: at any one time, some individuals wish to save, while others wish to borrow, and the banks provide the mechanism through which savings can be channelled from the former to the latter. Most importantly, this process allows firms to borrow to invest - enabling the economy to grow.

Panics occur in the event that savers - fearing losses - demand their money back, with the consequence that the system ceases to perform its essential function. The most iconic panics were those of 1930s America, but, as this book suggests, they were a reasonably regular event before then. According to Gorton, the "quiet period" of 1934-2007 resulted from a combination of carrots (bank charters), sticks (regulation) and the public insurance of bank deposits. Deregulation during the 1990s introduced greater competition in the banking system, reducing the size of the carrot and thereby creating an incentive for the movement of bank capital to the shadow banking system. Gorton argues that this below-the-radar movement left the economy vulnerable to panics once again.

The shadow banking system involves a market known as the repo market, and it is here, Gorton argues, that a panic took place in 2007. The repo market is where the banks themselves save with and borrow from each other - generally on a short-term basis. Securitised loans, including sub-prime mortgages, are used as collateral. The "shock" news that US house prices were falling caused concern about the value of the collateral. This made banks more reluctant to lend to each other, thereby bringing about a credit contraction and mass sales of assets - all of which forced the prices of housing and other assets further downwards, making the banking system insolvent. Banks would no longer lend to each other, and consequently could not lend to you and me. The lifeblood of the economy dried up - and to a large extent this situation has continued to the present day.

In putting forward this explanation of the crisis, together with policy proposals that could prevent a repeat in the future, Gorton draws heavily on both economic history and real-world economics. This is a great strength of the book, and one that is all too rare in the economic literature. We will not have learned from the crisis until real-world economics and economic history feature once again on the academic syllabus. This book is a big step in the right direction.

The body of the book consists of three academic papers - two of them written for Federal Reserve System conferences that took place in the midst of the crisis. Inevitably, therefore, while the book is certainly "groundbreaking", it is also technical, and aimed at economists and individuals working in the banking system. If you do not fall into one of these categories, but have longed to understand the difference between CDO and CDS, and MBS and SPV, then this could still be the book for you - although noting down each technical definition as it is introduced will pay off, as you will frequently refer back to it.

What you will not find in the book is a consideration of other - even potentially complementary - factors in the crisis: the short-termism of banks, loose monetary policy and global imbalances. Nor will you find reference to the work of academic economists who for a long time have suggested that the banking system sows the seeds of its own destruction. We are still waiting for a work that successfully knits together these many dimensions. Does anyone wish to write one?