If there's a conventional wisdom about how to respond to the financial crisis, it's that banks need higher capital requirements. President Obama, in his first presidential debate with Mitt Romney, said the Obama administration had said, "banks, you've got to raise your capital requirements." Mr. Romney agreed: "you need to have leverage limits." The free-market-oriented Wall Street Journal editorial page editorializes in favor of tougher capital requirements as a "critical reform," while the left-of-center New York Times editorial page mentions the Dodd-Frank Law imposing "higher capital requirements for banks" as a reason to vote for Mr. Obama.
For that reason alone, Gary Gorton's new book, Misunderstanding Financial Crises: Why We Don't See Them Coming, is worth a look. Mr. Gorton, a professor at Yale and a former consultant to AIG Financial Products, challenges that conventional wisdom on capital requirements. "Crises are about cash and not capital," he writes. "High capital ratios cannot prevent runs." In case that is insufficiently clear, Mr. Gorton goes on, "There is almost no evidence that links capital to bank failures."
Mr. Gorton brings to bear a historical perspective along with his refreshing willingness to challenge the conventional wisdom. He says the lack of such a historical perspective is one reason that the economics profession failed to see the crisis coming: "It used to be that economics PhD programs required at least one term of economic history, but this has disappeared. Many top economics programs that previously had two or three economic historians now have none."
Among the episodes that Mr. Gorton recovers from the past are the 1857 case Livingston v. Bank of New York, in which a New York court found "the mere fact of suspension of specie payments" was not sufficient to force a bank into liquidation. Another is the 1934 case Home Building & Loan Association v. Blaisdell, in which the Supreme Court upheld the Depression-era Minnesota Mortgage Moratorium Act.
The author also has an eye for illuminating quotes when it comes to more recent events. He reminds readers that White House economic adviser Austan Goolsbee said of AIG executives, "It's almost like these guys should have gotten the Nobel Prize for evil." And that Charles Grassley, a Republican senator, suggested that AIG executives resign or commit suicide.
Given that level of hostility from government officials, it is somewhat surprising that Mr. Gorton concludes by recommending regulatory changes that "would place the government in an oversight role in the securitization and repo markets." Which government overseer would Mr. Gorton like for those markets, one wonders? Senator Grassley, or Professor Goolsbee?
Disclosures: The publisher sent me a review copy. As usual, if you buy the book from the Amazon link above this site gets a share of the revenue at no additional cost to the book purchaser.