It’s a popular idea on the American left: repeal of the Glass-Steagall Act in 1999 unleashed greed and risk-taking in the financial industry, which led to the 2008 crash. It recently popped up in the HBO drama series The Newsroom.
A character on the show would have viewers believe that Glass-Steagall led “to the largest sustained period of economic growth in American history, a sixty-year expansion of the middle class, the largest increase in productivity and the largest increase in median income. We also won World War II, put a man on the Moon and a computer in everyone’s lap.” It’s amazing what one law can do.
But there was little expansion of the middle class in the fifteen years after the bill was enacted in 1933. Productivity did increase — after the United States entered World War II. Putting a man on the Moon probably had little to do with financial regulation.
The broader point is that Glass-Steagall ushered in an era of financial sanity that lasted until the end of the last century; and that the separation of banks’ commercial and investment activities was crucial to that.
The libertarian Cato Institute’s Mark A. Calabria disagrees, pointing out that the financial institutions that were most affected by the 2008 meltdown — Bear Sterns, Lehman Brothers, Merrill Lynch — were stand-alone investment banks.
They didn’t take deposits. And of course, Fannie and Freddie weren’t even banks.
Fannie and Freddie
The two government-sponsored enterprises affectionately known as Fannie Mae and Freddie Mac securitized and purchased millions of subprime mortgages in the years before the crisis, providing a false sense of security with their implicit government guarantee — which turned out to be an explicit one when push came to shove. Both entities were nationalized in 2008.
As a result, the federal government now assumes or underwrites nearly all credit risk on almost every new mortgage. The government is responsible for 100 percent of the default risk on $6 of the $10 trillion in outstanding mortgages.
It was the artificially propped-up housing market that got mixed commercial-investment banks, like Citibank, WaMu and Wachovia, in trouble.
The most “bizarre” assumption behind Glass-Steagall, writes Calabria, is “that somehow commercial banking is risk-free.”
Anyone ever hear of the savings and loan crisis of the late 1980s and early 1990s? No investment banking angle there. How about the 400+ small and medium banks that failed in the recent crisis? According to the FDIC, not one of them was brought down by proprietary trading.
Contrary to what proponents of reinstating Glass-Steagall believe, “diversification generally reduces risk,” according to Calabria. What the financial industry needs is not more government intervention or regulation, but less.