The great virtue of Slapped by the Invisible Hand is that it was written in real time, as the crisis unfolded. The book consists primarily of two essays that Gorton wrote for a pair of Federal Reserve conferences. The first was at Jackson Hole, Wyo., in August 2008, on the eve of the public crisis; the second was a session nine months later, on Jekyll Island, Ga. (where plans for the Federal Reserve System had been drawn up a hundred years before). It also includes a third paper, written 15 years earlier when the shadow banking system was just emerging, which provides historical perspective, and a coda, titled “A Note to Those Reading This in 2107,” which makes it clear why the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 probably will not on its own be enough to stop the next panic.
What happened, according to Gorton, was a classic panic, not all that different from the E. coli spinach recall in 2006 or the fear of mad cow disease that shut down British butcher shops a few years back — except that in this case, it was the pervasive fear of “toxic assets” that shut down the world economy for a time. Other observers are now reaching the same conclusion, in economics textbooks and journals, and, in all likelihood — since Gorton was among the first witnesses called to testify — in the December 2010 report of the Financial Crisis Inquiry Commission, chaired by former California state treasurer Phil Angelides. In other words, a consensus is emerging. But with Gorton’s book, you are there as the fog first begins to lift. You see how and when the narrative was framed. Moreover, Slapped by the Invisible Hand is tightly focused on prevention. You get a sense of how it could have turned out differently, if only the proper diagnosis had been widely shared among regulators at the time.
Why the star turn here? Gorton is not an ordinary economist. He has a master’s degree in Chinese literature, and earned an economics Ph.D. at the University of Rochester in 1983 with a dissertation on banking panics in the 19th century, which was highly unfashionable for the academic tastes of the times. After several years at the Federal Reserve Bank of Philadelphia, he moved to the Wharton School of the University of Pennsylvania and, eventually, to Yale. His most salient experience, however, was as a consultant to AIG Financial Products, where for more than a decade (beginning in 1996), he modeled markets for exotic financial products for the giant insurance conglomerate. Having knowledge of both policy history and current practice provided him with a privileged position from which to observe the events of 2007 and 2008.
At Jackson Hole, Gorton reminded his listeners of history that had been forgotten — that half a dozen panics had occurred in the era of national banking, which spanned the 50 years from 1863 (when Congress authorized national bank charters and established a uniform currency) to the creation of the Federal Reserve in 1913. They usually happened near business-cycle peaks, when people worried about losing their savings in a bank failure. Some unexpected piece of news would send depositors rushing to demand their money and, sure enough, since most of the money had been loaned out, the bank would fail, even if it was competently managed. (This is the situation everyone knows from Frank Capra’s film It’s a Wonderful Life.) Privately owned clearinghouses evolved to squelch rumors about member banks when they arose — sometimes squelching them successfully, sometimes not.
The Federal Reserve Board was created to deal with panics by imitating the Bank of England as “lender of last resort” to threatened banks. (J.P. Morgan had demonstrated the efficacy of this approach by single-handedly stanching the Panic of 1907.) But then the Fed itself panicked after the stock market crash in 1929 and permitted hundreds of banks to fail. So Congress created a number of safeguards of its own: insuring deposits, carefully defining banking, and restricting entry into the business. Depositors were reassured that they didn’t have to worry. And for the next seven decades, banking panics simply disappeared in the United States.