Have we learned our lesson?

It has been a bit over a year since Lehman Brothers went under, and the U.S. economy seems to be finding its bearing once again, at least in terms of GDP. As the panic of Wall Street's freefall subsided, we have seen rational reflection and discourse on the topic of reform among critics, and some also among decision makers. But the fervor for a regulatory uplift of banking laws witnessed during the presidential debates has seriously diminished and could go the way of healthcare reform – stymied in the tar of consensus building. What should be expected by the American public is a rule change on Wall Street that will prevent such a crisis from happening again, but this might not happen, and here is why.

The Late 2000s recession and the Financial Crisis of 2007-2009 were largely made possible by the removal a key regulatory safeguard. The Glass-Steagall Act of 1932-33, enacted in the wake of the Crash of 1929 was designed to prevent a repeat collapsing of the banking industry that sparked the Great Depression. Among other things, Glass-Steagall effectively protected the U.S. economy from the dangers of horizontal diversification of financial institutions. It separated commercial banks from investment banks in order to protect the savings of depositors from bad times in the world of investment banking. Commercial banks were barred from engaging in the securitization and trading of the types of derivatives made famous by the recent Subprime Mortgage crisis.

Since the 30’s, however, the world of economic thought has shifted from Keynesian towards a neoclassical, more laissez faire approach. Additionally, banks have poured many millions into a lobbying effort to loosen the rules, eventually winning over a majority of politicians. Congress repealed Glass-Steagall through a series of bills in 1980, 1982, and 1999. The deregulation resulting from the first two bills allowed set the conditions that made the Savings and Loan Crisis possible (this event has many disturbing parallels to our recent recession and also was paid for by taxpayers). Legislators ignored this warning, and continued the relaxations of Glass-Steagall, opening the floodgates for consolidation of the banking industry, the culmination of which was the Financial Services Modernization Act of 1999. This brought into legality the activities of companies such as Travelers, which by merging with Citigroup engaged in practically all arenas of financial services.

For the first time since the 1930’s, U.S. financial rules allowed for some serious leeway. The 2000s saw the birth of the shadow banking system, which meant Wall Street got really complicated. Financial intermediaries were allowed to do new things, and create diverse investment vehicles. This is not to say that this market is inherently bad, it increased the availability of credit, getting more capital to projects that need it, leading to greater economic growth, which is positively correlated to overall human welfare, yada yada yada. But, shadow banking is inherently risky (that shouldn’t require too much convincing), and in a few short years there was more money in shadow banking than in the traditional banking system. Additionally, much of Shadow Banking has virtually no relationship to economic productivity, and is, for all intents and purposes, a glorified casino. Then things went wrong… I would continue, but you already know how this story ends.

Here’s a big take away argument: We should have seen the crisis coming, because the dangers were clear from the start. Those who voted to undo Glass-Steagall were informed of the risks involved. Surely, no one would have been able to predict the precise details of the financial crisis, in all of its complexity, but the fundamentals were foreseeable, if not inevitable. The root cause of the crisis was the removal of the safeguards within Glass-Steagall, allowing commercial banks to underwrite derivates such as mortgage backed securities and structured investment vehicles. In short, the consolidation of financial institutions, blurring the line between depository and investment entities, is bad news.

The world’s biggest banks had to be bailed out because of regulatory changes that they themselves had sought for years. The taxpayers were used as the safety net because deregulation had allowed these institutions to become, in current jargon, “too big to fail”. The definition of this term is important. With regard to banks, “too big to fail” means that should an institution collapse, the savings of depositors like you and I would be endangered, and the likelihood of a “run” is greatly elevated. This is a very undesirable economic scenario, made far more probable by the deregulation mentioned above. With depository institutions separated by law from investment banks, “too big to fail” stops being a big issue; the personal savings of an average citizen is not jeopardized when an investment bank fails. Plainly stated: No bail out required. With this fundamental principle of separation, shadow banking can continue with far less regulation than would otherwise be required.

Now, you might be asking, what are our representatives considering by way of financial reform? If you are thinking along the lines of Nobel Prize winning economist Joseph Stiglitz, you might expect some sort of reenactment of Glass-Steagall… sorry, that wasn't included in the proposed reforms drafted by the White House in June.

I agree with Douglas J. Elliott of the Brookings Institute, that the Obama administration's financial reform proposal (see in [pdf] or [html]) introduces many very necessary changes, but does not go far enough. As might be expected, the administration's proposition was curtailed by anticipated opposition from Congress and Wall Street. In particular, the plan could have been much stronger with regard to the consolidation of regulatory bodies. There are far too many agencies with similar and overlapping responsibilities, rendering regulation far more complicated than it needs to be. This bill poses an opportunity to streamline the system – but this too is unlikely to happen.

The good news is that there is at least some political will to rectify a system that is clearly broken. I hope that our representatives are not so concerned with the profits of multinational financial institutions that they miss a chance to ensure that a repeat of the recent financial crisis never happens again. Glass-Steagall would be a great place to start, but the enormous amount of money possible only with it out of the way pretty much guarantees its political impossibility. We have to hope that whatever eventually gets through Congress will be good enough.