I don’t think that Robert Reich actually knows.
Some argue Glass-Steagall wouldn’t have prevented the 2008 crisis because the real culprits were non-banks like Lehman Brothers and Bear Stearns. But that’s baloney. These non-banks got their funding from the big banks in the form of lines of credit, mortgages, and repurchase agreements. If the big banks hadn’t provided them the money, the non-banks wouldn’t have got into trouble. And why were the banks able to give them easy credit on bad collateral? Because Glass-Steagall was gone.
Pointer from Alex Tabarrok. Reich seems to think that Glass-Steagall was some sort of magical regulation that allowed regulators to keep banks from making unwise loans.
In fact, my understanding (like most commentators, I have not actually read the law itself) is that it was intended to separate commercial banking from investment banking. That is, one type of institution could take deposits and make loans, and another type of institution could underwrite securities. It started to fall apart in the 1970s, when money market funds were invented, allowing investment banks to issue debt that looked a lot like deposits. This caused banks to complain that financial activity was going to shift out of banks, which was going to hurt banks and make bank regulation irrelevant. The 1980s were spent with lobbyists and legislators trying to work out a fair way for commercial banks to compete in investment banking and vice-versa.
Ironically, what Reich is describing, with commercial banks lending to investment banks, shows that the two were still somewhat separate even ten years ago. I am willing to be corrected, but as far as I know, there was nothing in Glass-Steagall to stop a commercial bank from lending to an investment bank. Repurchase agreements and lines of credit were not forbidden. And when Reich says that non-banks received mortgages from commercial banks, he is completely unhinged.
I continue to believe that the Nirvana Fallacy it what drives a lot of analysis of the financial crisis, and of government intervention in general. That is, if you believe that Nirvana is achievable through government intervention, then if we have disappointing outcomes it must be because government is being held back from intervening the way it should.
The overall Atlantic piece to which Tyler refers includes comments from some left-leaning economists that are actually reasonable concerning the irrelevance of Glass-Steagall. But on the whole, the left is locked into its Nirvana fallacy of financial regulation.
Hat tip to Alex Tabarrok.
I always assumed Glass-Stengell was a leftist hobby horse, as we had the S&L crisis with G-S and most of the worst players were not commercial regulated banks in 2008. (Also I believe the Frannie obsession or FDIC programs as being hobby horses on the right.) In reality, I assumed the growth of the shadow banking system was in response to G-S (for instance GE Capital and the neighborhood mortgage company.)
There is a case for separation of commercial and investment banking and that is as a check against unified financial political power. That this was weak was that the investment banks were still saved when they got into trouble. It had little role in the crisis since they were distinct, but that doesn’t mean it wasn’t a good idea.
What do you think of the limited purpose banking proposal advanced by Laurence
Kotlikoff and others? Link to PDF:
https://www.aeaweb.org/conference/2012/retrieve.php?pdfid=568
If GS isn’t enough, they’ll just argue that this proves that only bank nationalization suffices to really solve the problem.
I am not so sure that Glass Steagall was a bad idea, but Reich is completely out to lunch.
Why Glass-Steagall? It actually served a purpose. Premise: the banking system requires deposit insurance to prevent bank runs by depositors.
Unfortunately, deposit insurance represents a subsidy from the government to banks and hence indirectly to depositors, but is important to protect the integrity of the money supply. Moreover, the government’s resources are (or ought to be) limited, and so deposit insurance should be limited to covering only those financial instruments that are “money,” i.e. checking and similar deposits.
Given these merits, but desiring to constrain how widely the subsidy goes, neither bank shareholders nor depositors ought to benefit from the subsidy derived from deposit insurance for activities beyond those related directly to holding money in the form of deposits. So, the subsidies ought not to extend to banks investing in assets that are too risky.
So, Glass-Steagall was one way, but is not the only way, to contain the moral hazards inherent in insuring bank deposits. Limited purpose banking is another. Risk-based capital requirements has been another (but very difficult to implement efficiently).