For every right wing type who blames the Community Reinvestment Act for the 2008 financial crisis you’ll find left wing types who blame the the “repeal” of Glass-Steagall in 1999 for the same. Out of all the books about the crisis in 2008, the ones I felt were most enjoyable and insightful are:
I’ll refer you to those books to understand the causes and ‘ins and outs’ of the crisis. I will focus mainly on the history and in and outs of the Glass-Steagall Act and its repeal, in helping understand that its role in the 2008 financial crisis is probably overstated. I am not saying that it played no role, but it’s not as focal as the last century of monetary and housing policy, and the culture of risk-taking and distorted price data they created.
The History of Glass-Steagall
In the 1920s Federal Reserve Chairman, Benjamin Strong, had begun to expand credit during an already prosperous period. This prosperity followed on the large tax cuts by the Warren Harding and Calvin Coolidge administrations. This artificial credit found its way into a frenzy of foreign bond buying, as borrowing for post-World War I reconstruction was prominent by foreign nations. These bonds padded the earnings of US corporations who issued stock to raised money in order to buy these bonds.
Over time the excess credit led to overvaluation and an eventual stock market crash in 1929. This recession took years to recover from, becoming known as the ‘Great Depression’. I refer you to David Stockman’s “The Great Deformation” so you can understand why it lasted so long.
Whatever the reasons, the Great Depression happened and the US Congress never let a crisis go to waste – by exploiting the political environment in order to pass several laws regulating the financial industry throughout the entire 30s.
One of these laws was the Banking Act of 1933, better known as Glass-Steagall. The law provided for the following:
– The creation of the Federal Deposit Insurance Corporation (FDIC), which had an initial limit of 2500 (now 250.000) to insure bank depositors when banks fail. This effectively ended banking panics going forwards, introducing a new problem of bank failures.
– Gave financial institutions one year to choose to be either a commercial bank (checking and savings accounts) or a investment bank (stocks and bonds). It also forbade any financial institution from doing both. The idea being if commercial deposits are insured then they should make institution “safer” by removing the speculative elements from it.
– Created the Federal Open Market Committee, which is now the part of the Federal Reserve, which makes all the monetary policy decisions, i.e. whether the Fed should put money into or take it out of the financial system.
– Established Regulation Q, which regulated the rate which commercial banks offered. This was later repealed which played a role in the savings and loan crisis.
The Financial Modernization Act of 1999
Citigroup merged with Travelers, an insurance company, which brought insurance, commercial and investment banking under one roof. This was technically a violation of Glass-Steagall Act. Yet a year later the Financial Modernization Act was passed, which repealed the separation between commercial and investment banking.
The arguments made for this repeal were as follows:
– Allowed financial companies to diversify their products so they become more sustainable financial institutions. Usually during bad economic times insurance and savings accounts are popular, while during good economic times brokerage accounts become more popular. In a world of risk, people want safety, and in a world of safety, people want risk.
– Other countries did not have laws like Glass-Steagall, so financial companies could leave the USA and develop in countries without these types of restrictions.
The law passed and right afterwards you had the dot-com bubble, which perfectly facilitated financial consolidation: when there is financial downturn, institution look to merge with other institutions to form one strong enough to survive the downturn.
So Why Would it Cause Crisis?
I think people confuse the ’cause’ with those things that multiplied the pain. At the end of the day, the underlying cause of the recession was a correction of housing prices, although speculation via derivatives in housing among large and small financial institutions surely made the ramifications and depth of such a correction greater.
Did bigger financial institutions make the recession deeper? Sure. Bigger institutions are less likely to fail, but when they do fail, it’s painful. But companies like Lehman and Bear Sterns weren’t benefactors of the repeal of Glass-Steagall, as they were still only investment banks.
Did a complex web of credit derivatives make the recession deeper? Sure. Without a clear order in how these contracts would be resolved, no one knew if they were still in business; further freezing credit markets which many small businesses depended on.
So yes, all these aspects discussed about the financial industry made the crisis worse, but did not fundamentally cause it.
What Did Cause it Then?
Here is my honest and humble opinion, since what I’m about to propose is arguably immeasurable. There are two elements that, to me, lead to the run up on housing prices and layers of speculation built on it:
– A century of loose, more often than not, monetary policy and financial bailouts, which over time kept marginally increasing the risk appetite of the financial system for generations.
– A century of pro-housing policy from the Federal National Mortgage Association to the CRA, that distorted housing price data to make the housing market statistically look less risky. This allowed banks to underestimate the risk in housing in an already risk-prone financial culture, in order to ratchet up housing prices into a large correction.
You can’t really measure a culture’s desire for risk, nor do we know what housing prices would look like absent decades of pro-housing policy to say this with an kind of definitive certainty. Although I think these assertions are quite plausible and, if true, would illustrate the build up of economic malcoordination that would build up from years of economic intervention.
This post was written by Alex Merced.
The views expressed here belong to the author and do not necessarily reflect our views and opinions.
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