Weekend Reading: David Warsh: The Tardy Product: Gorton and Holmström
David Warsh: The Tardy Product: Gorton and Holmström: "When high theory is placed in juxtaposition to practice that has developed in the world itself, surprising new issues for the theory sometimes emerge...
...The most famous example of this is what happened in 1963 when Ford Foundation program officer Victor Fuchs asked theorist Kenneth Arrow to write about the medical care industry for the foundation.... Arrow unexpectedly surfaced the concerns known mainly to actuaries as “moral hazard” and “adverse selection”... fields for mischief and maneuver among human beings that economists previously had overlooked or ignored... [that] turned out to be enormously important.... Elaborated by Arrow and many others, under the heading of asymmetric information, Arrow’s paper was the beginning of the most important development of economic theory after 1950.
Something similar happened when, in August 2008, a historian of banking Gary Gorton... gave a detailed account... of an apparently short-lived panic in certain obscure markets for mortgage debt.... Bengt Holmström... discussed Gorton’s 90-page paper....
Sometimes, Holmström observed, opacity, not transparency, was a market’s friend. There is no evidence that the audience had the slightest interest in or understood what the two men had to say--at least that day. Talking afterwards... Gorton and Holmström quickly agreed upon the salience of Holmström’s surmise: it was entirely counterintuitive, but perhaps opacity, not transparency, was intended by the sellers of debt, banks and structured investment vehicles, and welcomed by the institutional investors who were the purchasers, in each case for legitimate reasons.... Over the next few weeks, each continued to think....
Holmström introduced a striking example of deliberate opacity: the sealed packets in which the de Beers syndicate sold wholesale diamonds. The idea was to prevent picky buyers from gumming up the sales--the process of adverse selection. In seminars, Gorton began comparing the panic to what has happened in the past after episodes of E. coli poisoning of, ground beef. Until the beef industry learned to identify where along the line the infection had occurred, and therefore which supply of ground beef to recall, people would stop buying hamburger altogether. Subprime risk, not large in itself, had been spread around the world, inside and outside the banking system. Suddenly the fear of “toxic assets” had become general, and there was no way of recalling the mortgages....
By the following April, they produced a draft paper, “Opacity and the Optimality of Debt for Liquidity Provision,”with Tri Vi Dang, a Columbia University lecturer who was enlisted to help. It began circulating slowly, but it was all but incomprehensible, say both men. Since then, Gorton has published three books... Slapped By the Invisible Hand: The Panic of 2007... Misunderstanding Financial Crises: Why We Don’t See Them Coming... The Maze of Banking: History, Theory, Crisis....
Holmström has been busy, too. The collaboration has continued. That first paper, titled at least for now “Ignorance, Debt, and Financial Crises: and known informally as “DGH,” is still circulating in draft.... Meanwhile... a second paper, written with Dang and Gorton’s former student Guillermo Guillermo Ordoñez, more accessible than the first... “Banks As Secret Keepers” argues that when banks take deposits (that is, when they produce what on their balance sheets is characterized as debt) and make loans (carried as assets on their balance sheets), which, of course, increasingly they sell (thereby producing debt on other balance sheets) in order make more loans, they labor under a special handicap: they must then keep secret the information they develop about their loans in order that the debt they manufacture can serve depositors/purchasers as money-in-the-bank at face value, without the fluctuations that are taken for granted in equity markets. Earlier this year, Holmström published... “Understanding the Role of Debt in the Financial System”.... It describes, I think, an Aha! moment of the first order.
Two fundamentally different financial systems were at work.... Stock markets existed to elicit information for the purpose of efficiently allocating risk. Money markets thrived on suppressing information in order to preserve the usefulness of bank money used in transactions and as a store of value. Price discovery was the universal rule in one realm; an attitude of “no questions asked” in the other. Deliberate opacity was widespread.... Serious mistakes would arise from applying the logic of one system to the other....
The new ideas suggest a very different interpretation of the financial crisis from the usual ones.... Those who created the global banking system... were responding not merely to their own itch to become rich (though certainly they were not unaware of the opportunities) but to legitimate public purposes that arose in growing markets--to raise money for new businesses, to finance trade, to broaden the market for home ownership, to safeguard retirement income, and so on....
Money markets are different from markets for wheat, or land, or airplanes, or pharmaceuticals, or art, everything and anything that isn’t money--that is the whole point of our story. They are opaque, designed to be taken at face value. Who wants to argue about the value of a $100 bill?... The basic story here concerns the financial crisis of 2007-08, the appearance six months later of ”Opacity and the Optimality of Debt for Liquidity Provision,” and subsequent events. The novelty of the findings argue for taking a longer approach than usual to the telling of it. I will set out the context in which these events occurred as best I can over the next fourteen weeks....
Macro has consisted mainly of unsettled arguments about the ’30s.... The Keynesian half of the profession was preoccupied with how the industrial economies of the world had gotten out of the Great Depression; the monetarist half with how it had gotten in.... The crisis of 2008 pretty much resolved the question... in favor of... economists who saw the history of the banking industry and the operations of the central bank as paramount, at least in the case of 2008.... The episode demonstrated the centrality of government’s role as steward of the economy and, in a crisis, as lender of last resort. That doesn’t disprove Keynesian arguments about the efficacy of economic stimulus so much as emphasize how non-parallel the argument has been. If the disinflation of the ’80s didn’t convince you that central bank policy was, well, central to economic performance, then the crisis of 2008 should have made up your mind. Money and banking matter....
[But] if you believe, as many monetarists do, that a simple rule governing the expansion and contraction of the supply of money is all that is required to achieve tranquility, then probably you lost. The Keynesian Paul Samuelson, and all the others of his ilk, won this debate.... Monetarists won the battle of what macroeconomics is about; Keynesians won the argument of how it would be done....
I like to think... that John Stuart Mill had the basic history of economic science right when he wrote in the first sentences of Principles of Political Economy in 1848:
In every department of human affairs, Practice long precedes Science: systematic inquiry into the modes of action of the powers of nature is the tardy product of a long course of efforts to use those powers for practical ends. The conception, accordingly, of Political Economy as a branch of science is extremely modern; but the subject with which its enquiries are conversant has in all ages necessarily constituted one of the chief practical interests of mankind, and, in some, a most unduly engrossing one. That subject is Wealth...
Mill wrote at a time when economics and finance were more or less the same thing. Twenty-five years later, the situation was beginning to change dramatically, with economics going in one direction, finance in another.... The gap has only gotten greater since then. And that’s where Gorton and Holmström come in. Kenneth Arrow, a brilliant theorist, recognized the potential significance of asymmetric information because he had studied to become an actuary as a young man. But neither Gorton nor Holmström knew enough by himself to spot the significance of opacity single-handed....
Had Gorton not studied banking history for 25 years, so that he knew that new forms of bank money regularly are developed and recognized a panic when he found himself in its midst; had Holmström not studied organizations and information economics for 25 years; and had both not had considerable experience themselves in markets: they could not have made their contribution. The story of their collaboration, set against the twentieth-century economics that they learned in graduate school, makes an interesting tale. So let’s say, here at the beginning, that this is a story about practice and theory and more practice and better theory in economics. It is a story about banks and central banks and why we have them. It’s a story about the relationship between the growth of knowledge and economic growth. It is, in other words, a history of economics since 2008.
