Let's start with the history: there were actually two Glass-Steagall acts, but what we're generally referring to is the second one, passed in 1933, which did a number of things.
- It regulated interest rates, including setting a rate of zero on demand deposits. This was rolled back decades ago, which is why you now get interest on your checking account, and banks strive to offer you an attractive interest rate rather than a free toaster when you open an account with them.
- It established the FDIC to insure bank deposits. Last time I looked, the FDIC was still there, keeping my $7.67 safe from harm.
- It separated investment banking and commercial banking, which is why Morgan Stanley and JP Morgan are two different institutions. This was effectively dead letter when Traveler's bought Citigroup in 1998, but Gramm-Leach-Bliley officially repealed this provision in 1999.
Given a history like this people wonder how repealing the law could have been a good thing. But a significant academic literature has investigated these claims and rejected them. Eugene White, for example, found that national banks with security affiliates were much less likely to fail than banks without affiliates. Randall Kroszner (now at the Fed.) and Raghuram Rajan found that (jstor) securities issued by unified banks were (ex-post) of higher quality that those issued by investment banks. A powerful book by George Benston went through the entire Pecora hearings which supposedly revealed the problems with unified banking and found them to be a complete sham. My colleague, Carlos Ramirez later showed that the separation of commercial and investment banking increased the cost of external finance (jstor). Finally, my own work (pdf) unearthed the real reasons for the separation in a titanic battle between the Morgans and Rockefellers.
Yet this meme keeps coming back and back, in my comments and elsewhere. Paul Krugman and Daniel Gross are too chicken to outright claim that the "repeal" caused this mess, but they sure do strenuously imply it.
They can't say it more directly because it's moronic. Even if you ignore the economic history indicating that Glass-Steagall didn't help the crisis it was meant to solve--even if you assume, arguendo, that the repeal was a bad idea--there's simply no logical reason to believe it had anything to do with the current mess.
Securitization was not introduced in the 1990s; it was invented in the 1970s and became popular in the 1980s, as chronicled in Liar's Poker. (As an aside, if you haven't read it, you really must. Especially now).
GLB had nothing to do with either lending standards at commercial banks, or leverage ratios at broker-dealers, the two most plausible candidates for regulatory failure here.
Most importantly, commercial banks are not the main problems. If Glass-Steagall's repeal had meaningfully contributed to this crisis, we should see the failures concentrated among megabanks where speculation put deposits at risk. Instead we see the exact opposite: the failures are among either commercial banks with no significant investment arm (Washington Mutual, Countrywide), or standalone investment banks. It is the diversified financial institutions that are riding to the rescue.
Bubbles happen. Trying to regulate them out of existence is folly. Of all the disturbing ideas that have emerged in the past few weeks, the prohibition against short selling baffles me most. Have we abandoned all free market principles? I ask this as a progressive, which contrary to some opinions on the right, does not mean socialist. To me, this all spells inflation. So I guess buy commodities? I suppose it depends on the extent of the global slowdown? Maybe I'll just follow Sarah Palin's lead, and take up subsistence hunting.
Paul Krugman and Daniel Gross are too chicken to outright claim that the "repeal" caused this mess, but they sure do strenuously imply it.
They never implied that repeal caused this mess, only that repeal helped make it worse. They both know, I am sure, that lax or unenforced regulations also contributed.
Swampfox: it's been interesting to watch the commodities prices as this crisis unfolds. Yesterday gold futures were way up and approaching $1000 an ounce. Today as people start to think maybe the fed has possibly saved us, reports have gold way down again.
To me, this all spells inflation. So I guess buy commodities? I suppose it depends on the extent of the global slowdown? Maybe I'll just follow Sarah Palin's lead, and take up subsistence hunting.
Didn't the Fed stop doing the M3 report about a year ago? Geez, I wonder why!! Of course it spells inflation. That way the Fed can, in a sense, reduce all this debt they are now taking on.
"Most importantly, commercial banks are not the main problems. If Glass-Steagall's repeal had meaningfully contributed to this crisis, we should see the failures concentrated among megabanks where speculation put deposits at risk. Instead we see the exact opposite: the failures are among either commercial banks with no significant investment arm (Washington Mutual, Countrywide), or standalone investment banks. It is the diversified financial institutions that are riding to the rescue."
Bingo.
I very much enjoy your posts and this was another excellent one explaining what did not cause the current financial mess. I don't remember seeing you post something about what has casued the crisis. In this post you briefly mention "lending standards at commercial banks, or leverage ratios at broker-dealers" as the likely regulatory failures but I gather those are not the only contributing factors the current crisis. A more comprehensive post explaining how we got into this mess would be great, or if you have already done that my apologies for not catching it.
Floyd-
See the post "What the hell just happened here?"
Floyd,
Here are my thoughts.
I work as an IT consultant and I've been involved in dozens of projects. At the start of each project there is usually someone I call "the voice of doom." The voice of doom is full of warnings and objections. In most cases "the voice of doom" is pushed out, either fired or taken off the project. Which is vital as 80% of the objections are not valid, the project will fall behind if we attempt to address each of those invalid objections.
The problem of course is the 20% of the objections that have some merrit....
I can only assume that at Bear, Lehman, AIG, etc. there were many "voices of doom". I would guess that in each case the person either figured out they needed to keep quite or they were pushed out.
The big management question is: knowing that no company can survive adressing the 80% of the objections that are merritless, how do we tease out the 20% that have some merrit?
It seems the problem is, no one gets ahead in corporate america by being a pessimist. Even short sellers get ahead by being optimistic about their pesimisim. That being the case, as a manager, how do you elicit negative feedback without it bringing your business to a halt.
Do any other country have a legally imposed division between investment banks and commercial banks? I think Japan might, but as far as I know, no other country does. If such a division was such a necessary and obvious practice, then why do so few countries do it?
For some reason, most commentators who discuss Glass-Steagle remind me of Stanley Kowalski discussing the Napoleonic code in a "Streetcar Named Desire."
Did you actually read this?
http://www.qjae.org/journals/qjae/pdf/qjae1_1_1.pdf
This is not good work. Asserting that if banks we're directing their depositors toward speculative enterprises that we're ruinous they wouldn't have had more depositors (read: customers) while very true assumes that these enterprises had already become unprofitable. When in truth in the stock market of the mid 20's everything was riding on the high end. So unless I had the specific stock selections for the specific bank, and then where their customers we're putting their money or the bank was allocating it I can't actually figure out if the Author's (Tabarrok) premise is correct. Also to use a single piece of corroborating data as the basis for an argument is poor work.
Then there is the J.P. Morgan thing now daddy was dead in 1913, so I'm thinking Tabarrok ought to at least have a JR. at the end of the name, or call him Jack or something to differentiate the son from the father. Thankfully Rockefeller does work since such a large portion of the family was involved. March 9, 1933 you have the beginning of the supposed conspiracy, June 16, 1933 Glass-Steagal is passed (the Bank Act).... Are you serious? No way the Democrats would do Rockefeller a favor like that 4 years into the depression. Especially given what they had put him through with his election, and what they did after.
Now to the relevant foolishness of having investment banks paired with commercial banks. It is a good point to note that outside of the S&L scandal in the 80's since Glass-Steagall we have had a very stable banking industry. Now only 9 years after it is officialy gone we have problems? Corroborating not compelling very true. Now look at the basic nature if you're a bank and the only way you make money is loans you are very keenly aware of this fact. MAKING SURE TO GET YOUR MONEY BACK!!!!! If you can use stocks and bonds now you have alternate sources of income, meaning you can afford to be loose with your credit, in short you can afford to lose more and if so you can chase riskier game. Which can only get you into trouble.
Megan,
With all due respect, this is a classic example of a great post that poisons its own well with a useless and trite reference to "the left" (and then attempts to add antidote by proposing an equal swipe at "the right"), when IMO such reference adds exactly nothing to the content while attracting sustained attacks by partisans.
Many people are making references to Glass-Steagall in respect to the current financial crisis. In your estimation, Glass-Steagall is irrelevant upon closer inspection. Why not just say as much and avoid salting it with gunpowder?
Megan,
Possible idea for a future post: How can all of these assumptions be true (as both you and I clearly believe)?
A) It is idiotic to think that "repeal" of Glass-Steagall led to this.
B) Neither Krugman nor most of the other left-leaning economists who imply (but don't say) repeal is responsible are -- in fact -- idiots.
C) Most (if not all) of them are also not evil people who seek political gain by spreading patently false information about important issues.
Why are they arguing this or at least implying it? Is it the sort of subconscious belief that keeps rational sports fans (who mentally know they cannot jinx their teams) still engage in or refrain from certain actions? If not, what is it?
The separation of investment and retail banking in 1933 struck me in the 1950s, when I first read about it, as an extraordinarily clear example of politicians closing the cowshed door after all the horses had walked out of the stable. Working in government, I kept it in mind as a prize example of the political need to be seen to be doing something, however irrelevant. It is, of course, quite high order nonsense; like Scientology. Therefore, it is not surprising that quite a few Americans (and a sprinkling in Europe) are still sold on it.
If Glass-Steagall's repeal had meaningfully contributed to this crisis, we should see the failures concentrated among megabanks where speculation put deposits at risk.
You mean like Wachovia?
Wachovia hasn't failed and won't.
Commercial banks with no significant investment arm and stand alone investment banks have indeed failed. The point remains.
"t is a good point to note that outside of the S&L scandal in the 80's since Glass-Steagall we have had a very stable banking industry."
Ben - are you serious? That is like saying that aside from the civil war the nineteenth century was one full of peace and prosperity for the U.S.
Ayner UWS-
War of 1812, Mexican-American war, Plains indians to the start of the Spanish-American War. Now find me something other than the S&L scandal that registers like that for banking? My point is that it was relatively tranquil. You can't hang gold standard, stagflation, trade deficits on banking.
Look folks I get that allowing banks to deal in the stock market frees up larger lines of credit,thus creating growth. My trade-off is the speed at which it moves. I'd rather be slower and more stable then running into the "20-year economic downturn" on top of the 10 and 5 year ones. This is worse than stop and go traffic and its a maleable if unsolvable problem. One that would be much more avoidable if we put a brakes on growth at the high end and then fret less when things break down. This entire thing is due to the accumulation of debt and not enough hard capital. Capital and Credit are not interchangable terms, and we need to stop treating them like they are.
"War of 1812, Mexican-American war, Plains indians to the start of the Spanish-American War."
By the standards of warfare these all amount to little skirmishes. That they are called "wars" at all points to how little actual wars the U.S. was involved in at the time. 83 years of essential peace between the War of 1812 and Spanish -American. "Outside of" the Civil War, of course.
Sorry, but you get to exempt the S&L crisis from banking scandals about as easily as a historian gets to exempt WWII from twentieth century European history.
"If Glass-Steagall's repeal had meaningfully contributed to this crisis, we should see the failures concentrated among megabanks where speculation put deposits at risk."
WTH?!?!? Am I missing something? What were Bear-Stearns, Lehmans and Merril Lynch?
Isn'[t there only 2 or 3 major investment banks left at this point? And weren't their collective arses saved for now by government bail-outs?
muirgeo:
Megan's "megabanks" are those banks that are commercial + investment banks. The banks you mentioned are (were) strictly investment banks.
"Possible idea for a future post: How can all of these assumptions be true (as both you and I clearly believe)?"
Scoop, I'm with you. I pick B. as false.
Megan, Please explain now how the Community Reinvestment Act and Fannie and Freddie securitized sub primes did not cause this?
Or, contribute. Thanks
Most European and all Canadian banks have commercial and investment under the same roof. Perhaps because it has been that way forever that the more conservative commercial bankers influence the culture more than in the 'States?
Anyway, the market seems to have decided that all stand-along investment banks except for Goldman must die. Personally, I think that is unfair speculation, but there you have it.
Myabe the argument is that the repeal of G-S forced the I-Banks which didn't marry a commercial bank to take even greater risks? I don't really see it, since they were already inherently more risky even prior to G-S. Maybe someone else has a theory?
To say that the repeal of Glass Steagall had nothing to do with the meltdown would seem to be claiming that secritization of mortgages had nothing to do with the meltdown.
Anyway Megan wrote a post a while back... " I know I saw that recession around here somewhere . . . " Well did you find it yet?
muirgeo -- The economy has grown at a tremendous clip this year. Credit crises and recessions are entirely unrelated. Is that strike three or four or five for you?
This is a great comment thread. I'm learning a lot, and what I think I believe is being challenged. It's really a shame that know-nothings like you have to intrude with caustic remarks. It sucks even more that your caustic remarks are stupid and wrong.
Megan,
You (or one of the web geniuses at The Atlantic) should fix your style sheet so that your bullet lists and block quotes are the same font and size as the rest of your text.
Merrill Lynch was not into commercial banking? Then what was this about?
Ray,
The terms "commercial bank" and "investment bank" are technical terms, not ordinary every-day descriptors.
It's been a long time since I was in banking, but as I recall, investment banks are not members of the Federal Reserve system and none of their deposits are guaranteed by the FDIC.
These two types of banks are regulated by different entitites and have to comply with different regulations. S&L's are also a different creature of law and are not commercial banks.
The mere fact that ML was trying to provide services similar to a commercial bank does not make it a commercial bank.
I had a Merrill Lynch money market (guess it still is, will soon be renamed or something) that was guaranteed by the FDIC. More here. The lines were certainly starting to be blurred. A few years down the line and I suspect commercial and investment would have become virtually indistinguishable in some cases.
Meanwhile, I don't trust anyone who says Wachovia can't or won't fail, given what has transpired in the past week and how so many analysts have been proven wrong.
It seems the problem is, no one gets ahead in corporate america by being a pessimist.
Absolutely true. Even when getting eaten alive by competitors and hemorrhaging market share.
That being the case, as a manager, how do you elicit negative feedback without it bringing your business to a halt.
Simple. Get to know your employees well enough to figure out who the genuinely smart ones are (hint: generally they aren't the butt-kissers). Some of the doomsayers have workable solutions but aren't given the time of day.
Perhaps if managers stop managing again and do their jobs rather than being preoccupied with climbing up higher the day they've been promoted. I find most people who get promoted these days don't do so because they are necessarily good at their jobs but are good at managing their own image in the company - which often leaves them little time to actually do their job well. They'll micromanage certain tasks of those under them to show their authority, but if you watch them closely everything they do is half-assed.
Hate to say it but a good recession would make companies strip off those excess layers of middle management and make them more effective in the long run.
I am not an economist but I was wonderng would this current economic crisis undo the publics faith in the conservative idea of free market based economy especially with the social conservative wing which encompasses most of working class and rural america or will it eventually cause a split within the republican party.
Ray,
Yes, Merrill Lynch owns an FDIC insured bank, and their ability to do so would have been limited prior to GLB. However, is that what got them into trouble? Most of Merrill Lynch's write downs seem to be due exposure to CDOs and subprime mortgages. Would Glass Steagall have prevented investment banks from being exposed to CDOs and subprime mortgages? If I understand the law correctly, it would not have.
In regard to Merrill Lynch's "Beyond Banking" product, brokerages were allowed to provide cash management services (i.e., checking account services) well before GLB.
I view the link between Glass Steagall and the mortgage crisis is a bit like the link between Saddam Hussein and 9/11. The link seem superficially reasonable, but no one has presented hard evidence of a link.
Let's see. The banking system is collapsing. A bill which significantly effected how banks operate which passed only 9 years ago played no part it it. Okee Dokee.
Hopefully it will become obvious that Greenspan's Fed is most responsible for the mess. Let's review. The purpose for which the Fed was created was to insure that member banks assets were of good quality and of sufficient quantity.
Now three of it's most important partners, Bear, Countrywide and LEH who were their Primary Dealers, and perhaps a hundred smaller banks have gone under or soon will. Destroyed by large quantities of bad debt. In the case of Bear and LEH gigantic mountains of it, much of it kept off their balance sheets in special entities, like Enron.
Greenspan's Fed didn't just enable the mortgage credit bubble, which was part of a much larger systematic credit bubble. It was a full partner and main cheerleader in what amounted to a Ponzi scheme.
As to his partnes; Paulson on Thursday night told a group of congress critters if they didn't do a bailout now, it would be Armageddon. Now I'm a nobody blue collar schmuk from the rust belt who is tuned into macro economics as a sort of hobby I
1 Thought 7 years ago that the banking and credit system were out of control and were creating a large systematic risk.
2 I knew, didn't suspect but knew, in Feb 07 when it became obvious that the top on real estate was in that a meltdown would occur in the mortgage backed security market and that this would cause very large systematic risks centered on the great Wall Street broker dealers.
Paulson worked for 25 years or more at the heart of Wall Street eventually becoming CEO of Goldman and he earned at least, counting stock options, at least $600 million doing it.
but Paulson just discovered how bad the problem was last week, or was it two weeks ago? Let me suggest he always knew. How could he not. I suppose it's possible he drank the Koolaid which was Free Market Fundamentalist ideology but not likely. Just assume he always knew it would end badly. Now he goes to congress like a made man mafioso and says 'It's a nice economy you've got there. It would be a shame if something happened to it'.
99.9% of the great depression was caused by the FED's decision to take currency out of circulation. p/e's were 140 in 1929 and margins were 10:1. it unwound in 1930 as it should have and the FED reacted by yanking the currency. there was literally no money in its phicical form to do buliness. the dame thing happened at the end of the civil war whene the gov. stopped printing green backs. the banking system had little to do with the problem historiclly and it has even less to do with the problem now. the government backed a trillion $ in worthless mortgage debt to buy votes. now we all have to pay. the fix is this - 30% down or rent.
Wachovia could fail. Primarily because it has a bunch of "Option Arms" in portfolio from its ill-fated acquisition of a West Coast S&L.
Making mortgage loans is a core commercial banking activity and certainly not prohibited by Glass Steagall.
Merrill Lynch has subsidiaries that are banks. They remain solvent and isolated from the dealer and parent company problems. Once again, not Glass-Steagall activities that caused the problem.
Post hoc ergo propter hoc.
The small minded leftists are trying to find a "bank" in a collapsed investment bank,or an "investment bank" in a collapsed bank. The problem, of course, is that they are ignoring the size of the entities. To prove GLB wrong or G-S right, you'd need to find a very large commercial bank done in by its investment banking arm, or a very large investment bank done in by its commercial bank.
What we're instead seeing is the failure of stand alone entities thanks to mismanagement of their primary businesses or a crisis of confidence in their primary businesses. Citi, for all the stick it got from "real" investment bankers, is not at risk. Lehman's gone, ML has been sold (to guys from Charlotte!) Meanwhile WaMu is teetering despite never even trying to get into I-banking.
This demonstrates the strength of the supermarket model - a huge balance sheet reduces the risk from and of external confidence crises. This comes at some cost in margins and serious increase in operational complexity but it saves the franchise.
Too bad that even smart people like Jeff Jarvis see something wrong with the markets and determine that "something" must be done. That they have absolutely no knowledge of the industry that they are demanding be relegated and no idea what the actual problems are is of no importance. Fun with the madness of crowds.
The horror! The horror! I know I promised I would stop reading your blog but morbid curiosity keeps drawing me back. Its amazing to me that someone with so little understanding of the hows and whys of our financial system feels free to pontificate and even make firm policy statements that have no empirical or even theoretical justification. Anyhow, here's a nice piece by Barry Eichengreen for Project Syndicae that could put you on better footing, if only you could admit how poorly informed you really are:
http://dailystaregypt.com/article.aspx?ArticleID=16596
The irony is that newspaper readers in Cairo are getting better information and commentary than North Americans relying on The Atlantic.
Cheers,
Jed
Jed, did you read the same article I did? The article seems in the main to agree with MM, and avoids making a lot of "those evil guys did it" accusations, much like MM. It really differs only in the shading of the issue. (Okay, it takes a swipe at the Bush tax cuts, but both MM and the article know enough to attribute the base cause to cheap cash inflows.)
Jed, Megan's post discussed how blaming the (partial) repeal of Glass Steagall is fundamentally misguided. The article that you link to says:
"Similarly, eliminating Glass-Steagall was fundamentally sensible. Conglomerates allow financial institutions to diversify their business, and combining with commercial banks allows investment banks to fund their operations using relatively stable deposits instead of fickle money markets. This model has proven its viability in Europe over a period of centuries, and its advantages are evident in the US even now with Bank of America’s purchase of Merrill Lynch."
This is supposed to be a rebuttal? Are you sure you linked to the right article?
So what's the argument against the equivalent, not-quite-as-loony belief on the right that if we hadn't had such tough redlining laws, or such deep government interest in expanding homeownership, this wouldn't have happened?