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Professor Gary Gorton's new book is mandatory reading for anyone who wants to understand why financial crises are a recurring feature across time and distance for capitalism. There are no secret solutions on the pages of Misunderstanding Financial Crises: Why We Don't See Them Coming for the simple reason that none exist. Instead, the book offers an explanation, relatively short and to the point. Considering how so many people misread cause and effect with financial crises, the book is an important contribution for peeling away the confusion.

The subject, of course, has attracted a deep and wide pool of analysis in recent years. But it would be wrong to assume that the events of late-2008 are now broadly viewed through an objective lens with an analyst's eye for identifying the source- the true source- of the trouble. Gorton sets the record straight with this brief, readable treatment on what should be obvious at this late date. Unfortunately, financial crises remain mysterious for many in the grand scheme of punditry. The good news: The Yale professor leads us out of the darkness, drawing on history to clarify the essential points that are so often ignored or overlooked.

His primary message is that there are no illusions about the 2008 financial crisis, or its many predecessors, both in the U.S. and abroad over the years. "Financial crises are about bank debt," he writes.

Banks and bank debt were at the root of every one of the 124 systemic crises around the world from 1970 to 2007 (some also involved currency crises in which the value of the domestic currency decline precipitously). Indeed, there cannot be systemic crises without bank debt. But bank debt is needed for conducting transactions and is necessary for an economy to function.

There's a long history in the private sector of trying to create bank debt that captures the unquestioned acceptance of sovereign debt-a 3-month Treasury bill, for instance. If you sell me a truckload of widgets in exchange for a relevant amount of T-bills, satisfaction is guaranteed because the means of payment is trustworthy. (Inflation is the perennial enemy that threatens government debt, of course, but that's another story.)

There is no need to determine the provenance of a U.S. Treasury bill-its value is known by all. Bank debt attempts to privately create this property of a Treasury bill, and this property is called liquidity.

The problem is that the private sector has a hard time replicating T-bills, currency, gold and other perfect or near-perfect mediums of exchange. Clever financial engineers can minimize this imperfection, which inspires overlooking the rough edges of bank debt when money and profits are flush and assets are priced for perfection. But there's always a fly in the ointment, and every once in a while the crowd discovers that disaster has been lurking just outside the door.

Markets are liquid when all parties to a transaction know that there are probably not any secrets to be known: No one knows anything about the collateral value and everyone knows that no one knows anything. In that situation it is very easy to transact. The situation where there is nothing to know or nothing worth knowing- no secrets- is desirable and allows for efficient transactions.

That ideal situation, of course, goes on holiday every now and again, and that's when the trouble begins. The best way to describe it is to call it what it is: A bank run. Everyone understands the basic concept, but this is also where many people become confused about the implosion in 2008. In the popular imagination, bank runs are events like the one depicted in the movie 'It's a Wonderful Life'. In that famous scene, which is burned into the public's collective memory, everyone wants to withdraw their savings at the same time, which, of course, is impossible. No bank can survive a complete and total request for liquidity at a single point in time. The inherent conflict in banking is that the institution is expected to satisfy liquidity demands of depositors while simultaneously providing credit to borrowers- borrowers who agree to repay the loan, with interest, through time. That means that all depositors can't be made whole at the same time.

No amount of banking regulation can change this fundamental conflict, short of requiring banks to remain liquid to the degree that they can repay all depositors at all times. Of course, that would mean that banks couldn't lend at all, which defeats the purpose of setting up a bank in the first place.

Okay, but what's that got to do with the financial crisis that exploded in late-2008? Wasn't that a new strain of crisis? No, Gorton explains. The details were new, but the fundamental issue didn't change. Although conventional bank runs weren't the primary trigger of the 2008 crisis, there was a surge in liquidity demand within the shadow banking world and its victims were institutional investors rather than John and Jane Smith. At the center of this run: Exotic forms of bank debt.

The commonality of crises is one of the points that the Panic of 2007-2008 should have made clear- the crisis mechanism was the same. In the Panic of 2007-8, it was sale and repurchase agreements (repo), commercial paper, and prime broker balances that were run on. This panic was not observable to most people because it involved whole markets where firms ran on other firms.

Observable or not, the result was typical when the demand for liquidity surged: A frantic rush to withdraw deposits, aka a banking panic. Like every other financial crisis, this one faced a familiar foe in the form of an inability to satisfy the demand for cash. In that scenario, there are two basic choices: Liquidate the banks (or quasi banking firms) or bail them out. For what should be obvious reasons, bailing out the banks is the usual and preferable response. It's never politically popular, but a sober review of the macro implications usually leads to the same conclusion: Allowing banks to die is economic suicide. It's the one industry that deserves a different treatment than all others.

It's always tempting to argue otherwise, and for what are sensible reasons. Moral hazard, after all, can't be dismissed, at least not entirely. But liquidating banks is a dangerous route due to all the interdependent links that tie various corners of the economy together through bank debt. When a bank fails- truly fails and its debt holders are left with nothing- there are deep and wide repercussions throughout the economy. Consider the recent real-world example when just one bank was allowed to go under and its assets were partially liquidated: Lehman Brothers in September 2008.

How did we reach that point? Hadn't we abolished all the errors of the past? Well, not entirely. "An important misunderstanding revealed by the crisis is that regulators and economists did not know what firms were banks, or what debt was 'money.' They thought that banks were only the firms that had bank charters, and that money was only in currency and demand deposits."

Allowing the shadow banking sector to remain unregulated was a big mistake. But that was a moot point when the run began. We may do better next time by improving the regulatory framework, but rest assured that another financial crises will strike one day and the same set of questions will come up.

The form of the bank debt doesn't matter so much. The issues and challenges that were front and center during the National Banking Era of the 19th century and beyond are still with us. What is relevant is if there's widespread use of the debt. If many individuals and/or institutions hold the debt, the potential for trouble is always just around the corner, even if the risk has been dormant for long stretches.

Better regulation can help, but Gorton reminds that raising capital requirements, for example, is no silver bullet. "The global financial crisis that began in the United States in the summer of 2007 was triggered by a bank run, just like those of 1837, 1857, 1873, 1893, 1907 and 1933." In other words, crises are liquidity events, which is why central banks are necessary evils. That alone doesn't wipe away the potential for financial crises, or the potential for poor policy choices. But central banks can at least keep a recurring problem from turning into an economic catastrophe.

From an investment perspective, there are important lessons here as well. "Financial crises are often preceded by credit booms, extended periods during which the amount of credit granted-through loans, bond issuance, and mortgages-rises." And it's hardly atypical that that the previous crisis arrived near a business cycle peak.

Gorton's book is a powerful reminder that we ignore financial history at considerable peril. If we have any chance of learning from the past, we must first understand it. Easier said than done. The cries to liquidate banks when they stumble, for example, has a wide fan base these days… still. History's financial lessons, it seems, don't come easy.

And the basic challenges are as thorny as ever. "To design a bank regulatory environment that addresses the vulnerability of bank debt and fosters economic growth is possible in principle," he writes. "But because of the paradox of financial crises, it might not be possible in practice."

Source: Gary Gorton's 'Misunderstanding Financial Crises'