In Misunderstanding Financial Crises: Why We Don’t See Them Coming, economist Gary B. Gorton provides a comprehensive examination of financial crises throughout history, illustrating why they remain misunderstood by the public, policymakers, and even economists. By dissecting the roots of these crises, Gorton argues that their unexpected nature lies in the inability to foresee the fragility of financial systems. His work challenges conventional thinking by exploring how systemic risks build up unnoticed until they result in severe economic downturns. Gorton’s insight is particularly timely in the wake of the 2008 financial crisis, which blindsided the world. This book serves as both a historical analysis and a warning for the future.

Gorton begins by laying the groundwork for understanding financial crises. A major theme in the book is that financial crises are not anomalies, but predictable events in systems where trust is a key factor. Gorton states, “Crises are an inherent feature of economies, and they occur when the banking system’s role in providing safe, liquid assets becomes disrupted.” He uses examples from U.S. banking history to argue that financial instability often comes from the failure to perceive risk in financial innovation, such as shadow banking.

One key anecdote is Gorton’s exploration of the 2007-2008 subprime mortgage crisis. He points out that while economists and regulators acknowledged rising debt levels, they failed to recognize the systemic risk these posed. As the crisis unfolded, Gorton recalls, “The problem wasn’t the housing market itself but the intricate and opaque financial products tied to it.” This lack of transparency allowed dangerous vulnerabilities to accumulate unchecked, leading to a collapse that few saw coming.

In this section, Gorton delves into past financial crises to highlight the patterns that repeat over time. He emphasizes that financial crises typically emerge in periods of economic prosperity when markets are buoyed by overconfidence. Gorton explains that the belief in financial markets’ invincibility often leads to risky behavior. For example, the Panic of 1907 serves as a critical case study. The crisis began with a failed attempt to corner the copper market, which triggered a bank run and spiraled into a nationwide financial panic. Gorton notes, “The public didn’t understand why their banks were failing, but in truth, it was rooted in the overleveraging that had been building beneath the surface.”

Another important historical comparison Gorton makes is with the 1980s savings and loan crisis. At the time, regulators and politicians were slow to react to the burgeoning crisis due to a lack of understanding of how rising interest rates and deregulation were unraveling the sector. Gorton argues, “The real danger lies in the lag between the emergence of risks and the acknowledgment of them by those in charge.”

One of the central arguments of the book is Gorton’s focus on the dangers of the shadow banking system. Shadow banks—institutions that operate outside traditional banking regulations—play a major role in modern financial crises. These institutions, while critical to financial markets, are largely invisible to the average person, which makes their collapse even more unexpected. Gorton explains that shadow banking, like traditional banking, is reliant on trust, yet it lacks the safety nets and regulations of the conventional banking system.

A memorable example is the collapse of Lehman Brothers in 2008. Gorton describes how Lehman Brothers was deeply involved in shadow banking, creating financial products that were nearly impossible to value accurately. “Lehman wasn’t just a single institution that failed—it represented a much larger and more opaque system,” Gorton explains. The opacity of shadow banking allowed risks to accumulate unnoticed, amplifying the effects of the crisis when trust was lost.

Gorton is highly critical of the regulatory responses to financial crises. He contends that regulators often mistake the absence of a visible crisis as a sign that the system is stable. However, Gorton shows that the real threat lies in the unrecognized buildup of systemic risk. One of his key arguments is that regulatory frameworks focus on past crises rather than evolving with the modern financial system. He writes, “We are always fighting the last war, implementing regulations based on the previous crisis, while new forms of risk quietly emerge.”

A particularly compelling anecdote is his discussion of the Glass-Steagall Act, which was designed to limit risks by separating commercial banking from investment banking. Gorton argues that while this act was effective in addressing the specific risks of the 1930s, its repeal in the 1990s left the financial system exposed to new types of risks—specifically, the kind introduced by the growth of shadow banking. “Regulators thought they had fixed the problem by addressing the symptoms, but they hadn’t solved the underlying issues,” Gorton asserts.

One of Gorton’s most insightful observations is his exploration of why financial crises are so difficult to predict. He argues that financial markets are inherently fragile because they are built on trust—trust that assets are safe and that liquidity will always be available. However, when that trust breaks down, panic ensues, leading to bank runs and a sudden collapse of the financial system.

He points to the role of asymmetric information in financial markets, where not all participants have equal access to information. In such an environment, a small piece of bad news can snowball into a full-blown panic. This dynamic was evident in the 2008 crisis, where the lack of transparency in mortgage-backed securities led to widespread uncertainty about the health of financial institutions.

In Misunderstanding Financial Crises: Why We Don’t See Them Coming, Gary B. Gorton provides a thorough analysis of financial crises, from their historical roots to their modern manifestations in the shadow banking system. His central thesis is that financial crises are inevitable and that their unpredictability stems from the systemic risks hidden within the financial system. Gorton’s book is not just a historical account but a cautionary tale, warning that unless we address the deeper structural issues in our financial system, future crises will continue to take us by surprise.

In the context of modern financial markets, Gorton’s insights remain incredibly relevant. As global financial systems become more interconnected and reliant on complex financial instruments, the potential for unseen risks grows. As Gorton emphasizes, policymakers and economists must move beyond fighting the last crisis and focus on understanding the new risks that continue to emerge. This book is essential reading for anyone looking to understand the inherent fragility of financial markets and why we consistently fail to see crises coming.