Was repealing Glass-Steagall the cause for the present Depression?

There is a view making the rounds now that repealing the Glass-Steagall Act of 1933 is the root cause for all of the excesses we have experienced — and by extension for the present economic Depression.  Glass-Steagall was enacted in 1933 in the first Great Depression in order to prevent many of the abuses we have witnessed in the past 10 years by separating commercial banking from investment banking and securities firms. The logic here is that conflicts of interest were held in check before the Depression-era Glass-Steagall Act was repealed by the Graham-Leach-Biley Act of 1999.  After Graham-Leach-Biley, the financial sector ran amok, leveraged up and generally went into irrational exuberance mode.  The financial sector now lies in tatters and another global Depression has begun.  Therefore, we need to re-institute Glass-Steagall, lest we suffer another Depression in the future.

I don’t buy this line of argument for a second.  The fact of the matter is the universal banking model which Glass-Steagall ended has always been in existence in nearly every other modern industrialized nation both before and after the Great Depression.  There is zero connection between the universal banking model and this Depression.  But, that doesn’t stop many from putting forward this argument.

In The Nation, Robert Scheer says the following:

The reversal of Glass-Steagall unleashed the robber barons, as was freely conceded by Goldman CEO Blankfein in an interview he gave to the New York Times in June of 2007. “If you take an historical perspective,” Blankfein said, gloating back then about the vast expansion of Goldman Sachs, “We’ve come full circle, because that is exactly what the Rothchilds or J.P. Morgan the banker were doing in their heyday. What caused an aberration was the Glass-Steagall Act.”

The “aberration” being the sensible regulation of Wall Street to prevent another depression, which now seems dangerously close at hand. Since Glass-Steagall was repealed in 1999, Goldman Sachs experienced a 265 percent growth in its balance sheet, totaling $1 trillion in 2007.

What we need is an honest accounting of how we got into this mess, beginning with an investigation of the role of Goldman Sachs as the most insidious Wall Street player. But we are not likely to get that from an administration populated by Goldman’s Washington allies.

While, the article is principally concerned with the question of conflicts of interest at Goldman Sachs, Scheer is clearly taking aim at the repeal of Glass-Steagall. He has the wrong target altogether. Deregulation is the problem, not Glass-Steagall.

Before the Great Depression, the United States had what is known as the universal banking model. This allowed financial institutions to take deposits, lend funds, issue securities, and arrange merger transactions all under one roof. The problem with this model is that there are inherent conflicts of interest. So, in the 1920s, we saw institutions flogging the shares of companies for whom they issued securities to their depositors. Many of these companies were of dubious quality and were deep in debt to the same institutions. So the banks obviously had every incentive to reduce exposure and heap the burden onto their own depositors. These abuses were uncovered after the stock market crashed in 1929 and the Great Depression began, eventually leading to the Glass-Steagall Act of 1933.

Meanwhile, in Europe there was a Depression in the1930s as well. However, banks continued operating in the universal banking model in countries like France, Germany and Switzerland without interruption. None of these countries suffered depressionary collapses in the years since the Great Depression. Clearly, the universal banking model is not the source of the problem then.

The real problem is deregulation — and this is where the Scheer article is on target because many of the proponents of the disastrous deregulation of the 1990s are in the new Obama Administration making policy decisions. I have deep misgivings about the quality of their banking crisis solution given their prior failings and the degree to which firms like Goldman Sachs have ingratiated themselves into economic policy. But, that is a topic for another time.

Here, I am discussing deregulation and the origins of the deregulation movement. After the Reagan-Thatcher revolution, fans of deregulation and the efficient market hypothesis gained sway in economic policy circles. The idea, particularly in the United States and Britain, was that government was a burden suffocating business with regulation. Reducing the burden by de-regulating would free business and financial markets to operate more efficiently, creating benefits for everyone.

The problem with this ideology is that deregulation  usually means irrational exuberance and turmoil for the deregulated market. For example, in Sweden, the housing bubble that preceded their banking system failure and nationalization was preceded by deregulation. In the United States, immediately after the airlines were deregulated, the industry experienced turmoil and repeated bankruptcy. After the financial services deregulation in the U.K in 1986, irrational exuberance led to scandals and a housing bubble which crashed spectacularly in the early 1990s.

Deregulation is a term used at once to mean reduced regulation and reduced oversight. But, oversight will always be necessary, particularly in markets newly open to competition. In the United States, companies within the financial services industry were allowed to enter new markets after 1999 without sufficient regulatory oversight. There is nothing wrong with JPMorgan Chase issuing securities, practicing investment banking, lending money and taking deposits as long as the regulators are there to prevent conflicts of interest and excess.

With easy money from low interest rates as an elixir, irrational exuberance begins to make financial services firms drunk with greed. It should be expected that some are going to cross the line. And that’s where vigilance is needed: to prevent predatory lending, excess leverage, off-balance sheet investment vehicles, and enormous OTC derivatives exposure. These are the excesses of the last decade. They have nothing to do with Glass-Steagall and everything to do with deregulation.

Sources
Wall Street in Washington – The Nation
Regulation – Wikipedia
Big Bang (financial markets) – Wikipedia
Repealing Glass-Steagall: The Past Points the Way to the Future – Federal Reserve Bank of Philadelphia, 1996