I ran across this Robert Scheer piece in The Nation. Sheer laments the fact that the Obama administration seems determined to not bring back the Glass-Steagall Act, while McCain is trying to reinstate the regulation. Apparently, Larry Summers supported the repeal of the Glass-Steagall when he was with the Clinton administration. Scheer believes that Summers is behind the Obama administration’s current position.
Scheer doesn’t give his reasons for supporting a new Glass Steagall, but he quotes McCain extensively. McCain’s comments are essentially a populist rant against “fat cat bankers on Wall Street.”
That’s a problem. I’m all for a new Glass Steagall, but let’s get the reasons right. Populist rants only confuse things.
The Glass-Steagall Act, passed in 1933, was part of the response to the Great Depression. The component relevant to today’s debate was the restrictions on the breadth of financial institutions’ operations. Investment banks were restricted from commercial banking, and commercial banks were similarly restricted from investment banking. An investment bank engages in transactions involving capital, securities, mergers and the like. Commercial banks take deposits and make loans.
The repeal of Glass-Steagall, in November 1999, was supported by both political parties. The arguments for repeal were that it would reduce risk by diversification and that advances in financial technology meant that risk was low.
The diversification argument sounds reasonable: Banks could diversify, and if one business was in trouble, the other probably won’t be in trouble. But, there is a problem with that argument. Financial theory and experience is clear. Stockholders can diversify for themselves. Businesses should concentrate on their core competency, the one where they maintain a comparative advantage.
The diversification argument also implicitly assumes a relatively low correlation between the returns from the various businesses. Financial panics throughout history have demonstrated that when things go bad, the correlation goes to one. When things go wrong, they go wrong everywhere.
The argument that financial technology has improved, and we now know how to do things with low risk is an old one. I refer readers to Reinhart and Rogoff’s book This Time is Different: Eight Centuries of Financial Foll. In it, these respected economists document the plethora of financial panics this type of thinking has created.
We do need to reinstate the separation of bank business. Let’s do it for sound reasons. While we’re at it, let’s limit the maximum size of any corporation. We also need to get rid of the Too Big To Fail concept.