Glass-Steagall 2.0

by Benjamin Studebaker

Senator Elizabeth Warren (D-MA) has a new idea–she wants to bring back repealed portions of the Glass-Steagall Act of 1933. The bill is, surprisingly, co-sponsored by John McCain (R-AZ). Warren’s student loan scheme was ill-conceived, but is this idea better? Let’s find out.

The Glass-Steagall Act was enacted by the Roosevelt administration during the depression in order to reduce system risk in the financial system and thereby restore public confidence in it. It primary purpose was to separate FDIC-insured low-risk commercial banking from high-risk investment banking, so that the average person could put money in the banks without worrying that the banks would take excessive risks with that money, and so that the state really could keep its promise to ensure deposits. The act has loopholes, decayed, and was in many parts regulated away, but the straw that broke the camel’s back came in 1999, when sections 20 and 32 were repealed. Nobel laureate Joseph Stiglitz describes the result:

Given what the economy has been through, it is clear that the federal government should reinstitute some revised version of the Glass-Steagall Act. There is no choice: any institution that has the benefits of a commercial bank – including the government’s safety nets – has to be severely restricted in its ability to take on risk.

There are simply too many conflicts of interest and too many problems to allow commingling of the activities of commercial and investment banks. The promised benefits of the repeal of Glass-Steagall proved illusory and the costs proved greater than even critics of the repeal imagined. The problems are especially acute with the too-big-to-fail banks.

The imperative of reinstating the Glass-Steagall Act quickly is suggested by recent behaviour of some investment banks, for whom trading has once again proved to be a major source of profits.

The alacrity with which all the major investment banks decided to become “commercial banks” in the fall of 2008 was alarming – they saw the gifts coming from the federal government, and evidently, they believed that their risk-taking behaviour would not be much circumscribed. They now had access to the Fed window, so they could borrow at almost a zero interest rate; they knew that they were protected by a new safety net; but they could continue their high-stakes trading unabated. This should be viewed as totally unacceptable.

There is an obvious solution to the too-big-to-fail banks: break them up. If they are too big to fail, they are too big to exist. The only justification for allowing these huge institutions to continue is if there were significant economies of scale or scope that otherwise would be lost. I have seen no evidence to that effect. Indeed, the evidence is to the contrary, that these too-big-to-fail, too-big-to-be-financially-resolved institutions are also too big to be managed. Their competitive advantage arises from their monopoly power and their implicit government subsidies.

In sum, in the aftermath of the gradual dismemberment and eventual repeal of Glass-Steagall, banks became very big and they began to take larger risks, risks that made it more difficult for the state to effectively guarantee funds in the event of a collapse. To the extent that there have been issues with public debt in the economy in recent years, this is because the state ended up on the hook for a lot of private debt in its effort to stabilize the financial system during the financial crisis. It is ultimately the result not of profligate state spending, but of risky private sector lending which the state came to believe it necessarily had to back via the “too big to fail” argument.

We should be clear here–a fully functional Glass-Steagall would not have prevented the financial crisis, it would merely have made the fallout of such a crisis more manageable by keeping banks smaller and reducing the average person’s stake in their success. Smaller banks can be bailed out at lower cost, and their failures are less catastrophic. No single financial reform is a magic bullet, in part because there are a great many issues with the financial system each of which stacks upon the others to create instabilities.

A new Glass-Steagall, properly constructed, would not prevent an investment bank from failing, it would only ensure that:

  • The failed investment bank is small, so its collapse is manageable
  • The FDIC is not legally obliged to save it
  • The average person’s assets are not at risk when investment banks fail

It puts up a fire wall between high-risk lending and the wider economy, containing damage in the former so as to minimize negative consequences for the latter. The market economy relies on the threat of failure being genuine to curtail risk, so the state needs to alter the circumstances of the financial sector so that businesses within it can well and truly fail without creating economic consequences that the state cannot credibly promise to allow its citizens to endure. We need to let banks fail, but we need the adverse effects of those failures to be contained, so that citizens who did not themselves lend foolishly are minimally harmed.

A new Glass-Steagall should also not merely be a resurrection of the 1933 law–it should be updated, to close loop-holes and incorporate new financial behaviors and securities that were not invented until the 60’s, 70’s, and later. Warren and McCain should do their research and consult widely.

All this said, the chance that a new Glass-Steagall (or something like it but with modern refurbishments) passes through this congress marches on an infinite regress toward zero. If this is a congress that can’t pass appallingly reactionary immigration reform, what chance is there for bringing back Keynesian controls killed during the presidency of a democrat?

A law like this would have had better chances under a McCain presidency, which would have forced the Republican Party to the center and prevented the rise of Tea Party hardliners. Of course, under a McCain presidency, we’d also have already marched into the waiting jaws of the Syrian Civil War. There’s no winning here.