A popular notion among leftists in the United States is that the 1999 repeal of the Glass-Steagall Act set the stage for unbridled greed and gambling in the financial sector which led to the crash of 2008. The theory was articulated two weeks ago in an episode of HBO’s drama series The Newsroom.
A character in the show would have us believe that Glass-Steagall led “to the largest sustained period of economic growth in American history, a sixty years 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 a single law can do.
In fact, there was little expansion of the middle class in the fifteen years that followed the bill’s enactment in 1933. An increase in productivity really only occurred after the United States entered World War II while putting a man on the moon probably had little to do with financial regulation.
The larger point though is that Glass-Steagall inaugurated an era of financial sanity that continued into the postwar period up to the end of the last century; that the separation between banks’ commercial and investment activities was critical to that.
The libertarian Cato Institute’s Mark A. Calabria takes issue with that statement, pointing out that the financial institutions that were most affected by the 2008 meltdown, including Bear Sterns, Lehman Brothers and Merrill Lynch, were all stand alone investment banks. “They didn’t take deposits. And of course, Fannie and Freddie weren’t even banks.”
The two government-sponsored enterprises affectionately known as Fannie Mae and Freddie Mac securitized and purchased millions of subprime mortgages 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 at the expense of billions of dollars.
As a result, the federal government today assumes or underwrites all of the credit risk on practically every new mortgage that is originated. With regard to outstanding mortgages, the government is responsible for 100 percent of the default risk on about $6 trillion of the roughly $10 trillion market.
It was the artificially propped up housing market that got banks that did combine commercial and investment activities, like Citibank, Wachovia and WaMu, into trouble.
The most “bizarre” assumption behind Glass-Steagall, however, according to 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 seem to believe, “diversification generally reduces risk,” writes Calabria. What the financial industry needs is not more government intervention nor regulation but less of both.