Friday, October 30, 2009

Glass-Steagall

The House Financial Services Committee, headed by my congressman Barney Frank, recently reported out a bill that would place some regulations on the banking industry. These include restrictions on secondary mortgages and mortgage-based securities (requiring more cash backup), and provisions dealing with banks that are "too big to fail." (You can read the details elsewhere.) Aside from the predictable opposition from banks, there was also opposition from people who didn't think the legislation went far enough to protect us from a repeat of the 2008-2009 banking crisis. One of the rallying cries of this segment of the opposition is "Bring Back Glass-Steagall!"

Well, I'm not an economist, but I did a bit of reading about the Glass-Steagall Act(s) -- there were actually two of them. The first one, in 1932, enabled the Federal Reserve to help refinance the banks during the Great Depression. This had to do with "rediscounting" loans or "notes," and also related to the switch away from gold-backed currency. This first act is not the one of most concern these days.

The second Glass-Steagall Act (1933) did two important things. First of all, it set up the Federal Deposit Insurance Corporation (FDIC) which insures bank deposits. This was crucial in restoring faith in the banks after their failures during the Depression. The second thing it did was to separate banks into two types: commercial and investment, and to forbid one type from offering the services provided by the other. A commercial bank is what I suppose most of us think of as a bank: it makes loans and gives mortgages, accepts deposits and pays interest, and offers services like checking accounts, CDs etc. An investment bank, on the other hand, deals with corporations. It underwrites (finances) stock offerings, speculates in stocks, and creates all sorts of financial "instruments" such securitized mortgages (mortgages bundled into stock offerings), credit-default swaps ("insurance" on possibly bad loans) and other "derivatives." To get an idea of how this plays out, check out a book such as Liar's Poker by Michael Lewis.

Before Glass-Steagall, any bank could act as a commercial bank or investment bank or both. A bank could use deposits to finance securities speculation, for example. If the risks didn't pan out, the depositors could be left holding the bag. As the story goes, banks that were exclusively commercial were afraid and envious of the money-making potential of investment banks; correspondingly, investment banks were greedy for the large funds that depositors could provide. Banks that combined both functions seemed to have a tremendous advantage if sheer money-making potential was the object. Furthermore, regulators were anxious to insulate depositers from speculation with their savings; creating the FDIC could not be possible in this atmosphere. Thus, the main provision of Glass-Steagall II was to require that banks be either commercial or investment banks, but not both.

This is not to say that commercial banks couldn't buy and sell stocks and bonds under Glass-Steagall: they could, but only of certain types and quality, which were regulated. Similarly, investment banks were allowed to make certain types of commercial loans. But, the general thrust of the law was to separate the two functions of banks.

Whatever the theory, the fact of the matter was that Glass-Steagall worked well. Before it, bank crises fueled by speculation were common; for the 35 years it was in effect, there were no such crises; however, less than 10 years after it was repealed in 1999 the 2008-2009 debacle unfolded, returning banks to the disaster level of the Great Depression.

I have spent the past week or so reading articles, blogs and commentary on the "bring back Glass-Steagall" proposition. Of course, it is anathema to so-called conservatives and other deregulators, who seem to cling to an odd academic faith in their own studies about how the act stifled competition and the free market, and if anything made the economic climate more risky. Some even praised Citibank, at least up to the moment its precarious condition became clear. On the other hand, some commentators don't think that the continuation of Glass-Steagall could have prevented the recent crash.

In any case, the Act was repealed in 1999 under the instigation of Senator Phil Gramm of Texas, a reactionary on every possible front, and advocate of the corporate position on banking, energy, taxes etc. (Don't get me started on Phil Gramm.) The vote to repeal in the Senate was largely along party lines, with the Republican majority winning the battle. It passed the House more handily, and President Bill Clinton signed it.

I'm inclined to say: just look at the empirical evidence. Before and after Glass-Steagall there were major failures of banks due to speculation, while during it (1935 - 1999) there were none. In general, de-regulation of industry has been a failure, dispite its proponents' theories. Economics and politics are inexact fields, so their theories don't "prove" anything (Gramm has a Ph.D. in, you guessed it, economics). Ultimately, one tries to learn by what actually happens.
I think that we must once again regulate banks very closely -- something that it is clear they can't and won't do for themselves. Something along the lines of Glass-Steagall is a partial step -- but improvements must be made in the light of what we have learned from the recent meltdown. In addition to the Frank bill, we should have a marketplace for "derivatives" that is scrupulous and transparent: they need their own special rules.

One way to avoid the "too big to fail" problem is to split off the commercial from the speculative very strongly, as in Glass-Steagall. If a commercial bank is in trouble, the depositors are protected by FDIC. If we must protect a bank, let it be a commercial one that serves a useful social function in a capitalist society: lending to businesses so that they can conduct business. If an investment bank is in trouble, let it fail and let its speculators lose what they must. One of the arguments for profit in a capitalist society is risk: no risk no justification for profit. But risk is risk and heat is the nature of the kitchen.

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