Sunday, September 28, 2008

More on Glass-Stegall

There has a been a lot of talk recently about the Banking Act of 1933, commonly known as the Glass-Steagall Act, especially those provisions of the act that concerned the separation of commercial from investment banking, which is what most people have in mind when they use the term Glass-Stegall. I fear the significance of the act has been widely misunderstood in the press, and let me try to correct some of confusions, if I can be allowed a post which is more professorial than most of my efforts.

When the 1933 act went into effect, it was not making a new distinction, but trying to restore an old one. When modern American investment banking got underway in the late 19th century, it was almost entirely handled by private banks, that is, banks that were organized as partnerships, and not as corporations. (All commercial banks, by definition, are organized as corporations.) The reasons for this are complex, but it has to do with the excellent ties of private bankers to European capital like J.P. Morgan (to Britain) and and Kuhn, Loeb (to Germany) and the fact that membership on the NYSE was limited to partnerships. Starting in the early 20th century, there began to be some underwriting by commercial banks, and this became increasingly pronounced in the 1920s, when many of the bigger banks established security affiliates that underwrote corporate and government securities, but through 1933 the lion’s share of the underwriting remained the domain of private bankers. Glass –Steagall forced commercial banks out of underwriting, and private banks had a choice between continuing to have deposits or underwriting, and a few prominent private banks, notably J.P. Morgan, reorganized as commercial banks. But the whole point was to isolate what was thought to be the riskiest and most speculative part of the banking business, underwriting, from commercial banking.

Okay. The Glass Steagall wall worked for a while, and then became progressively eroded starting in the 1970s, and long before it vanished it was widely seen as the part of the problem. I have found myself re-reading in recent days a book by one of my old professors at NYU, Vincent Carosso’s Investment Banking in America, which appeared in 1970. Now of all the professors I had at NYU, he was probably the most conservative. (I ran into him at the opera on evening, after a performance of Kurt Weill’s masterpiece, “The Rise and Fall of the City of Mahagonny” with an great agit-propy libretto by Berthold Brech, and staged appropriately by the Met, with the chorus coming down the aisles waving protest banners. I loved it. I asked Vince what he thought and he said, shaking his head, without a hint of irony, “cultural bolshevism!”) Anyway re-reading his account of Glass-Steagall, I was surprised that how strongly he supported it, and argued that the securities affiliates of commercial banks had indeed engaged in risky behavior and imprudent speculations, and that though some of the critics of investment banking were half-baked and half-cocked, that’s what happens in a democracy, and the final act preserved the essential features of both investment and commercial banking. Twenty years later attacking his book had become a cottage industry among conservative free marketers, who argued that the Glass-Stegall distinction had become a dangerous anachronism, and that Carosso had gotten it wrong.

Rather than delve further into this controversy, what is perhaps most interesting is that by the 1990s it had indeeed became anachronistic, but not for the reason Glass-Steagall's conservative critics assumed; underwriting was no longer the bread and butter of investment banks, and they were happy to cede large portions of their underwriting business to commercial banks. Investment banks had become, more than anything else, institutions that traded heavily for their own account in anything that seemed like a plausible investment. The basic distinction between investment banks and commercial banks remained as it always had been—investment banks were less strictly regulated and far more speculative in their business ventures than commercial banks. And it is this, that in the end, has brought down so many banks on Wall Street in recent weeks.

We will not be able to revise the distinction between commercial and investment banks , and in some ways that isn’t the point. The whole point of Glass-Steagall was to control speculation and rampant speculative activities in the banking industry. And in a new environment, what some are calling the “new new deal” this is what we face again, to create a framework that allows for some market operations, curbs speculation, and keeps the lender of last resort from lending as promiscuously as it has done in recent weeks. The debate on how to really fix the financial system, beyond providing the largess of the American people to Wall Street has barely begun. And in this debate, the proper understanding of our economic history is essential.


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