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Why Democrats Fixate on Glass-Steagall

Megan McArdle is a Bloomberg View columnist. She wrote for the Daily Beast, Newsweek, the Atlantic and the Economist and founded the blog Asymmetrical Information. She is the author of "“The Up Side of Down: Why Failing Well Is the Key to Success.”
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Fun fact: During the 1943 professional football season, the World War II draft had so depleted the ranks of football players that the Pittsburgh Steelers and the Philadelphia Eagles were forced to unite their teams into a joint production that became colloquially known as “the Steagles.” In a heartwarming turn, this plucky band of men went on to one of the winningest seasons in the history of Pennsylvania football. That was, alas, their only season; the next year each city fielded its own team, and the proud name of the Steagles retreated into history.

I’m beginning to think that we should revive it, however, not for football players, but for those intrepid souls who continue to fiercely agitate for the return of the Glass-Steagall financial regulations. Like the Steagles, these people are not daunted by the many obstacles in their path. Like the Steagles, they are passionate in their determination. Probably also like the Steagles, they mostly don’t know much about Glass-Steagall.

And we desperately need a name for Team Steagles, because they seem to have become a powerful force in the Democratic Party. Last night’s Democratic debate, like the first one, featured lengthy paeans to the joys, and urgency, of a modern Glass-Steagall act. Somehow, an obscure Depression-era banking regulation has turned into a banal political talking point. Or worse -- a distraction.

You, like the Steagles, may not know much about Glass-Steagall. That’s all right. There is no particular reason that most of us should know about Glass-Steagall, and many people manage to live perfectly happy and fulfilling lives anyway.

Here's a quick introduction: The first thing you should know is that there are actually two Glass-Steagalls. For some reason, Washington likes to refer to many laws by the names of their congressional sponsors, rather than the actual title of the law, which is why many people know our most recent major campaign finance law as McCain-Feingold rather than the Bipartisan Campaign Reform Act of 2002.

Senator Carter Glass of Virginia and Representative Henry B. Steagall of Alabama, both Democrats, co-sponsored two major financial bills. The first concerned the operation of the Federal Reserve system, which is complicated. When most people speak about “bringing back Glass-Steagall” they are referring to the second law, otherwise known as the Banking Act of 1933.

This act had a number of provisions, the most important of which are:

  1. The creation of the federal deposit insurance program
  2. The forcible separation of commercial banking and investment banking activities (except that commercial banks could still buy lots of government bonds, because hey, look who’s writing the law)
  3. Outlawing interest rates on checking accounts, and capping the interest rates that could be paid on other sorts of accounts, colloquially known as “Regulation Q”
  4. The creation of the Federal Open Market Committee
  5. Tighter control by the Federal Reserve over the activities of banks, and reporting requirements for said banks to facilitate same

There were also some fiddling rules about things like bank officers borrowing from their own banks.

Glass-Steagall II was never “repealed.” The FDIC is still very much around, as is the FOMC. The Federal Reserve still has quite a lot of power to regulate banks. If you get control of a bank and use it to write yourself unlimited loans, you can still expect to spend quite a bit of time in the pokey when you get caught.

However, Glass-Steagall II has been extensively modified by subsequent regulation. For example, amendments through the 1940s modified the FOMC to make it more like the modern version. The rules about interest rates were eventually scrapped, which is why you now get 0.0025 percent interest on your checking, instead of a free toaster for opening an account, the way Grandma did back in the good old days. And the provisions limiting the entrance of commercial banks into investment activities (and vice versa) were gradually relaxed, and then abolished with Gramm-Leach-Bliley (the Financial Services Modernization Act of 1999).

Calls to “bring back Glass-Steagall” are, in fact, almost always calls to bring back this one provision. The average person agitating to bring back Glass-Steagall (a group which includes Martin O'Malley and Bernie Sanders), probably doesn’t know quite what the FOMC does. They are not overly concerned about the danger of interest-bearing checking accounts. But boy, do they want the commercial and investment banks split apart.

Elizabeth Warren is the current captain of the Steagles, but other Democrats are certainly playing for the team. In the first Democratic debate, O’Malley delivered lengthy and impassioned speeches on the need for “a modern Glass-Steagall that creates a firewall so that this wreckage of our economy can never happen again.”

Last night’s debate featured a retread of this meme, with O’Malley and Sanders competing to see who could deliver the most passionate love-oath to Glass-Steagall (the winner, presumably, to go to the prom with Glass-Steagall on his arm), while Hillary Clinton, playing cool, said Glass-Steagall was probably fine but not nearly enough for her. 

As a friend noted after the first debate, it would be an amusing and depressing exercise to get any of these candidates in a room with some economists and ask them to explain how Glass-Steagall could have prevented the 2008 crisis. For there is a small problem with the Steagles argument: It’s very hard to think of the mechanism by which the repeal of this rule made any significant contribution to the meltdown.

Let's imagine that the repeal of Glass-Steagall, and the resulting mingle of investment banking and commercial banking, really did create a financial crisis. What sort of crisis would you expect? Probably the worst problems would be concentrated among the big “universal banks,” while strictly commercial banking operations, and “pure-play” investment banks, would weather the storm fairly well. This is the opposite of what we saw. The problems appeared first at Bear Stearns, and then Lehman Brothers, straight investment banks and lenders like Countrywide. The pure-play banks that didn’t go under were saved in part by turning them into bank holding companies so that they could more easily tap Fed funds. Had Glass-Steagall still been in effect, we might well have seen the cascade of failures continue onward through Morgan Stanley and Goldman Sachs, making everything worse, not better.

This is why you don’t hear a lot of experts calling for the return of this rule. Those who do want it reinstated don’t claim that it would have prevented the financial crisis. For example, I quote Raj Date and Mike Konczal of the left-wing Roosevelt Institute, from their paper “Out of the Shadows: Creating a 21st Century Glass Steagall”: “The loosening of Glass-Steagall prohibitions did not directly lead to the financial crisis of the past few years.”

Why, then, do so many people want it back? 

  1. Fighting “Too Big to Fail.” This has become a catchphrase of the financial crisis, and it has led many people to think that the size of the banking institutions was somehow the main cause of the meltdown. In fact, the problem was the complexity and financial structure of the markets, which could have taken down a bunch of small firms as easily as it did a few large ones -- as happened during the Great Depression. 
    Splitting banks into different kinds of institutions demonstrably did not guard against collapse, or the risk of contagion; many of the split institutions got into big trouble. 
  2. Moral hazard/protecting the taxpayer. This is Warren’s argument. If you want to engage in complicated investment activity, you shouldn’t do it using taxpayer-guaranteed accounts. This logic means that any bank covered by the FDIC should not be in the investment business. This sounds reasonable as far as it goes, but it actually doesn’t go that far. In 2008, the taxpayer stepped in and bailed out a lot of firms that had no federally insured deposits, because their failure would have had disastrous knock-on effects. Covered by FDIC or not, there is now an implicit guarantee -- in extreme situations. Also … deposit insurance does not protect bank managers from the downside of risk-taking; it protects depositors. Managers who mess up still lose their jobs.  
  3. Exotic political economy arguments. Some with more financial expertise argue that ending the rule served as a substitute for much more prudent reforms that might have been undertaken (this is Date and Konczal’s argument). Or that the end of the rule allowed for larger banks with more powerful in lobbying Washington, or had some other indirect and nebulous effect on the regulatory climate.
    These arguments are hard to prove or disprove. The claim that giant banks are more powerful as lobbyists is not very convincing. Small banks and firms do just fine in their lobbying efforts, because they band together with other banks into a conglomerate. That can be more powerful than a big firm, because there’s a small bank in every congressional district. That sort of local pressure matters a lot, which is why auto dealers get so much protection from legislators.
  4. Naïve eyeballing. The universal banking restrictions in Glass-Steagall were repealed in 1999. Less than 10 years later, we had a financial crisis. QED. This is a popular argument among people who have not spent enough time on this site.

Proposing effective banking regulations requires mastering a pretty arcane body of knowledge about an industry with a lot of interconnected parts. Doesn't that sound kind of … hard?

Which ultimately explains the passionate attachment to Glass-Steagall. It is the perfect Washington Issue: a proposal of negligible impact but great popular charm. It is a way for politicians to sound as if they are addressing some major problem without having to go to the trouble of actually doing so. Glass-Steagall’s major appeal is not that it would work, but that it can be explained in under a minute to someone who doesn’t know anything about financial markets. Try doing that with the Basel III capital requirements.

And thus Team Steagles grows. The first Steagles lasted for only one brief, glorious year. The reincarnation just won't die.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Megan McArdle at mmcardle3@bloomberg.net

To contact the editor responsible for this story:
Philip Gray at philipgray@bloomberg.net