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Glass Steagall: The Real History
Many wise people are now recognizing that the repeal of Glass-Steagall was one of the few saving graces of the current crisis. Let's thank President Clinton (and Phil Gramm) for that wise bit of deregulation. The following potted history of the law, however, is all too typical:
Glass-Steagall was one of the many necessary measures taken by Franklin Delano Roosevelt and the Democratic Congress to deal with the Great Depression. Crudely speaking, in the 1920s commercial banks (the types that took deposits, made construction loans, etc.) recklessly plunged into the bull market, making margin loans, underwriting new issues and investment pools, and trading stocks. When the bubble popped in 1929, exposure to Wall Street helped drag down the commercial banks....The policy response was to erect a wall between investment banking and commercial banking.
Given a history like this people wonder how repealing the law could have been a good thing. But a significant academic literature has investigated these claims and rejected them. Eugene White, for example, found that national banks with security affiliates were much less likely to fail than banks without affiliates. Randall Kroszner (now at the Fed.) and Raghuram Rajan found that (jstor) securities issued by unified banks were (ex-post) of higher quality that those issued by investment banks. A powerful book by George Benston went through the entire Pecora hearings which supposedly revealed the problems with unified banking and found them to be a complete sham. My colleague, Carlos Ramirez later showed that the separation of commercial and investment banking increased the cost of external finance (jstor). Finally, my own work (pdf) unearthed the real reasons for the separation in a titanic battle between the Morgans and Rockefellers.
Thus, the history of banking before Glass-Steagall and now our recent experience after is consistent, generally speaking unified banking is safer and repeal was a good idea.
Posted by Alex Tabarrok on September 19, 2008 at 07:24 AM in Economics, History, Law | Permalink
Comments
I think Glass-Steagall protected institutions that were - for whatever reasons -separated, basically because there was no alternative to using their services. So, the repeal of Glass-Steagall made them somewhat less stable and now they are combining with commercial banks like Bank of America, at least those who can (and aren't as reputable as Goldman Sachs).
Also the repeal created some huge and unmanageable institutions like Citigroup, which probably never should have existed in this form.
So, I think that, while, as such, a world without Glass-Steagall would probably be better, the repeal (as in: change) did probably cause problems.
Posted by: IWantCookieNow at Sep 19, 2008 7:44:25 AM
"So, I think that, while, as such, a world without Glass-Steagall would probably be better, the repeal (as in: change) did probably cause problems."
Did you not even read the post to which you commented? The empirical academic literature demonstrates the opposite conclusion from your whimsical counterfactual statement about how you think the world might have been without repeal.
You should do some serious reading at Robin Hanson's "Overcoming Bias" blog before you make another post with a conclusion based on your feelings that is directly contradictory to the evidence.
Posted by: Blake at Sep 19, 2008 8:46:17 AM
Eugene White, for example, found that national banks with security affiliates were much less likely to fail than banks without affiliates.
How well did he control for confounding variables?
If for example banks that didn't gamble on the markets were banks that were too weak to take the risk, you might get that result.
Or if for one reason or another the banks that gambled were more likely to get bailed out.
Randall Krozner (now at the Fed.) and Raghuram Rajan found that (jstor) securities issued by unified banks were (ex-post) of higher quality that those issued by investment banks.
Again, which is the cause and which is the effect?
Carlos Ramirez later showed that the separation of commercial and investment banking increased the cost of external finance (jstor).
That sounds like it would be a hard fact. But was cheaper external finance worth the Great Depression?
A powerful book by George Benston went through the entire Pecora hearings which supposedly revealed the problems with unified banking and found them to be a complete sham.
That isn't surprising. Of all the economics done in 1932, how much of it would stand up today? But their wrong analysis doesn't say whether their conclusions were wrong.
Finally, my own work (pdf) unearthed the real reasons for the separation in a titanic battle between the Morgans and Rockefellers.
That's fascinating. But it doesn't address whether the result was an improvement or not. Probably every law that strongly affects financial giants has involved a titanic battle between financial giants. Maybe one side wins. Was it the right side? It depends.
What we have now is unacceptable. We need some sort of regulatory change that will make sure it never happens again.
I would prefer that the changes cost us less than 1%/year growth in GDP, but I'd accept up to 2%/year reduction in growth. Because the result of the travesty will certainly be a wealth transfer from taxpayers to thieves. What good does it do us to grow the economy and give more than we grow to them?
If as seems plausible Glass/Steagal was not the best legislation to prevent this theft, what would work better?
If you're a professional economist with expertise in this area, the ball is in your court to propose legislation that will keep this from ever happening again, with minimal bad effects.
Posted by: J Thomas at Sep 19, 2008 8:50:34 AM
"So, I think that, while, as such, a world without Glass-Steagall would probably be better, the repeal (as in: change) did probably cause problems."
You should do some serious reading at Robin Hanson's "Overcoming Bias" blog before you make another post with a conclusion based on your feelings that is directly contradictory to the evidence.
Read the post yourself, and read about bias.
The post presented no evidence whatsoever to contradict his claim.
Posted by: J Thomas at Sep 19, 2008 8:56:42 AM
First of all, at the top of page 2 of the PDF the author says "bares" when he means 'bears". Doesn't inspire confidence in the whole thing.
It is long on assertion and short on explanation. My knowledge of the topic is minimal to say the least but, doesn't asserting that unified banking is safer run counter to common sense? And don't current circumstances bear this out?
Posted by: whosonfirst at Sep 19, 2008 9:07:07 AM
Quick response to J Thomas. Of course, the papers I cite controlled for other variables and used advanced statistical techniques to uncover, as best as possible, cause and effect. That is what academic research is. You don't get a paper in the AER if it can be shot down by someone writing a blog comment.
Posted by: Alex Tabarrok at Sep 19, 2008 9:24:59 AM
Alex-
Ouch!
Posted by: Rich Berger at Sep 19, 2008 9:34:16 AM
Yes, Alex, but do you personally affirm that they did their statistics correctly?
Posted by: J Thomas at Sep 19, 2008 9:37:08 AM
Smack down; hurt feelings; must demonstrate dominance; flame war in 3....2....1....
Posted by: josh at Sep 19, 2008 9:40:33 AM
A few (but only a few) of the comments on both of our G-S posts today are very off. They show just how widespread is the presumption that the absence of Glass-Steagall is at fault. But a look at the evidence (and indeed not even a "close look") shows that the burden of proof is exactly on the other foot. There simply isn't a good argument that the absence of Glass-Steagall caused major problems, either before or after G-S. Some people are simply reiterating that G-S absence is at fault and asking us to prove the contrary. Alex and I are saying that putting the blame on G-S absence simply "isn't there" in terms of being a serious argument. Alex and I are right.
Posted by: Tyler Cowen at Sep 19, 2008 9:47:34 AM
I don't think it's the absence but the change from have to have-not.
And yes, this is completely unempirical and unscientific and stuff, but that's no reason to insult me. I did read the post but not all links, especially not the gated.
Posted by: IWantCookieNow at Sep 19, 2008 9:56:16 AM
I agree with Tyler. :)
Posted by: Alex Tabarrok at Sep 19, 2008 9:57:42 AM
And in the long term, America will IMHO benefit from the absence of Glass Steagall.
Posted by: IWantCookieNow at Sep 19, 2008 9:59:59 AM
Posted on the other topic but also should go here.
Look at the failures, to this point none of them have been unified big banks YET.
They have been
1) Two quasi government agencies not regulated as banks.
2) Three Investment Banks without comercial banking.
3) An insurance company (not a bank)
And the banks that have been in the most trouble Wachovia, WaMu etc do not combine investment banking and traditional banking to a large extent.
Who has held up? BofA, JPM, Citigroup. Big unified banks.
I can't find much to blame in GLB.
Posted by: eccdogg at Sep 19, 2008 10:01:47 AM
From what I understand, all these papers say "universal banking works, so repealing GS is fine". I think that's slightly flawed (remember, I'm being unscientific, but I do use my head) because not having something in the first place is not the same as repealing it.
Posted by: IWantCookieNow at Sep 19, 2008 10:04:39 AM
@eccdog: Citigroup! You might have forgotten, but this bank is in deep trouble.
Posted by: IWantCookieNow at Sep 19, 2008 10:06:23 AM
"Eugene White, for example, found that national banks with security affiliates were much less likely to fail than banks without affiliates."
Even if this is true there are problems with this thinking. It is likely that while bigger entities are less likely to fail (according to the paper), once they do fail it is a major catastrophe. Maybe if entities fail more often when smaller in scope, the problem would not affect the entire financial system.
Posted by: luke at Sep 19, 2008 10:06:32 AM
I'm just a peasant, but it seems to me that both Alex and Tyler's posts hit are spot-on and I'd like to thank them for pointing out the obvious. It seems to me that those who rushed in to denounce them are less interested in the facts than obtaining some imaginary partisan advantage. Failing that, they'll settle for sowing the seeds of confusion, repeating their illogical and inaccurate claims until people of good will throw up their hands in despair. This is not something new. It has become SOP in almost all political and economic discussions in recent years.
Posted by: RW Rogers at Sep 19, 2008 10:09:04 AM
Whos': "And don't current circumstances bear this out?" Unified banking, by its very presence in the sector, is only one influence - AMONGST MANY - on our current economy. Maybe things would be worse if Glass-Steagall was still in effect. I seriously question any empirical study of economics as being able to accurately predict or explain cause and effect. There are too many issues of degree that cannot be readily controlled even if a perfect understanding of all possible influences were possible. We are not trying to prove physical facts in economics but trying to understand the push/pull of differing influences (both in type and degree) on human behavior/interactions, by extension, societal trends. In the end what has happened is to be expected; we missed something, felt its consequences, and reacted to the best of our ability. Think of it as being a global game of bash-a-mole.
J Thomas: "If you're a professional economist with expertise in this area, the ball is in your court to propose legislation that will keep this from ever happening again, with minimal bad effects." You give too much credit to economists. Even if they did put together a visionary long-term model the fact the government leadership changes too quickly and that external conditions will inevitably change make those models useless. Additionally, fundamental beliefs about what is good for society varies greatly and the reality is that what is good for those that hold power and influence is often detrimental to those who are living paycheck-to-paycheck.
Our society is too big to fail and too diverse to achieve utopia; and thus is stuck gyrating between the good times and the bad.
Posted by: David J at Sep 19, 2008 10:09:35 AM
Alex, the majority of this evidence (cannot comment on the book, and barring your own book of course) seems to simply indicate that diversified banks were better able to withstand the crisis than purely commercial banks.
Is it not possible that these diversified banks still caused the crisis and were just able to survive it? I am not sure what the causal mechanism would be...but is it even a possibility?
Posted by: Robert Olson at Sep 19, 2008 10:10:50 AM
"A few (but only a few) of the comments on both of our G-S posts today are very off. They show just how widespread is the presumption that the absence of Glass-Steagall is at fault. But a look at the evidence (and indeed not even a "close look") shows that the burden of proof is exactly on the other foot. There simply isn't a good argument that the absence of Glass-Steagall caused major problems, either before or after G-S. Some people are simply reiterating that G-S absence is at fault and asking us to prove the contrary. Alex and I are saying that putting the blame on G-S absence simply "isn't there" in terms of being a serious argument. Alex and I are right."
I think what is at issue here is that pre-deregulation the markets didn't melt down. Post-de-regulation, the markets did melt down. I would say the burden of proof is on YOU as professional economists to make it clear to the layperson why that deregulation wasn't a problem, or the millions of people whose lives have gone to shit because of this problem have every right to call for draconian restrictions on the markets and tie the hands of the people who clearly are at least partially at fault in this issue.
Posted by: engineer at Sep 19, 2008 10:13:03 AM
Eccdog, you argue that the banks that are hurt the worst are not the ones that Glass-Steagal would have affected. And so GLB was not at fault.
But in general the guy who starts a ponzi scheme isn't the main loser when the ponzi scheme fails.
If the big unified banks have created a crisis that causes weaker banks to fail, that could be a bad thing even if the big unified banks come out of it OK.
The argument shouldn't be whether GLB is good for unified banks, the argument should be whether GLB is good for the world economy.
Posted by: J Thomas at Sep 19, 2008 10:14:34 AM
"Engineer" is just piling on top of the mistakes. There have been several different kinds of (partial) deregulation. The repeal of Glass-Steagall is one of them but not the only one. The main claim is that there is no good argument linking G-S repeal to the recent problems. You still might hold a presumption against the other forms of deregulation (and I'll try to cover those soon), but that doesn't justify a presumption against G-S repeal. You've actually got to make an argument as to how it caused things to go wrong. The data suggest that it helped, not hurt.
Posted by: Tyler Cowen at Sep 19, 2008 10:20:24 AM
"Thus, the history of banking before Glass-Steagall and now our recent experience after is consistent, generally speaking unified banking is safer and repeal was a good idea."
"Of course, the papers I cite controlled for other variables and used advanced statistical techniques to uncover, as best as possible, cause and effect. That is what academic research is."
I seriously question any empirical study of economics as being able to accurately predict or explain cause and effect. There are too many issues of degree that cannot be readily controlled even if a perfect understanding of all possible influences were possible.
Alex is arguing that the studies he quotes determine cause and effect enough that we should accept their conclusions.
Posted by: J Thomas at Sep 19, 2008 10:21:47 AM
I knew someone would question Citi in the list, and I agree that they have had problems. But they have not gone bankrupt
Relative to the others I would rather hold equity (or bonds) in Citi than Morgan Stanley or WaMu.
As to the Ponzi scheme. How did GLB help create it? It is stupid to say that well we had no crisis before it and now we have one so it had to have an effect.
Why do you think it created the situation? I can't find the path. Most of the problems seem to have been created by investment banks not unified banks.
If anything GLB seems to have been a stabilizing factor in this crisis.
Posted by: eccdogg at Sep 19, 2008 10:38:41 AM
