Through Glass-Steagall, Darkly

There is much talk of bi-partisan stimulus packages in Washington these days, touted by Nancy Pelosi, Ben Bernanke, and even Mr. Harvard MBA-in chief himself. Oh, I don’t know. Some stimulus to the economy probably can’t hurt in the form of increased spending can’t hurt. Questions of whether further tax breaks can do anything other than increase income inequality in this country seems unlikely. And it isn’t clear to me how the Fed cutting interest rates, to fix a crisis that was basically caused by the low interest rates that catalyzed excessive mortgage lending, isn’t an example of pouring oil on a fire.

In general I have nothing against Keynesianism (though I must say in this case I have my worries about its efficaciousness) , but the mere application of stimuli, as the major political actors in Washington seem to want to do, really doesn’t deal what seems to me the real cause of the current crisis; the structure of the financial services industry in this country, and its lack of effective regulation. What made the New Deal reforms work was not mere pump priming, but acts of inspired statesmanship like the creation of the SEC, some hard and fundamental thinking about how finance was working in this country, and some fundamental changes to that structure.

In particular the New Deal reforms called for separation and partitioning of the financial industry into constituent parts, so a crisis in one part would not necessarily bring down the entire structure. The Glass-Steagall Act of 1933, which separated underwriting and investment banking from other sorts of loaning activities, was central to the New Deal reforms, and it worked pretty well, stabilizing the commercial banking industry, and giving investment banking space to lick its wounds and eventually recover, and it played an important role in providing a pattern for the post World War II economic success of the United States.

But by the 1960s and 1970s, disintermediation and the breaking down of barriers was the was the cry of the financial services industry. Why shouldn’t commercial banks be able to directly underwrite? And why shouldn’t investment banks be able to loan money for mortgages. Bankers started to complain that they were being held hostage to an archaic New Deal reform, that contrary to accepted principles, put road blocks into the free and unfettered operation of the market. And in little bits, really starting in 1986, when commercial banks were given the right to underwrite municipal bonds, Glass-Steagall was dismembered, until in 1999, in one of the Clinton administration’s inglorious moments, it was repealed altogether, allowing copulation between investment banks and commercial banks to thrive, and this in turn has contributed to (so far) two financial crises, the dot-com crisis (where the so called “Chinese walls” to separate stock sales and underwriting were largely ignored, in the name of disintermediation) and the current housing crisis, where banks first made reckless loans and mortgages, and then created incredibly complex derivatives (a form of security) to try to spread the risk on sub-prime loans throughout the financial industry. These derivatives did their job so well, and spread the risk so widely, that none of the banks that underwrote or purchased their securities have a real sense of their exposure, and hence the multi-billion dollar losses reported by Citibank, Merrill Lynch, Morgan Stanley, et al.

Look, no one is saying that Glass-Steagall is a panacea, or that its reintroduction would solve all the current problems. But there is a need for Democrats (and I suppose Republicans) to take a hard and critical look at how the financial industry is structured, and then suggest and institute sweeping reforms. Alas, because of the closeness of Wall Street to the Democrats, and the need for the raising of endless amounts of cash, little of this is going on among the three major candidates, beyond some justifiable moralizing about predatory lending. But let the Democrats take a page from the New Deal, and use this occasion to think hard about how to use government to strengthen the economy and better the lives of our citizens.