The Glass-Steagall Act, also known as the Banking Act of 1933 (48 Stat. 162), was passed by Congress in 1933 and prohibits commercial banks from engaging in the investment business. This act is an example of principled regulation of business because it (1) protects private property of citizens, (2) encourages efficient banking practices, (3) eliminates exorbitant Wall Street profits which is the basis of much government and banking system collusion and cronyism, and (3) eliminates the cost of much government oversight and unproductive legal costs.
It was enacted as an emergency response to the failure of nearly 5,000 banks during the Great Depression. The act was originally part of President Franklin D. Roosevelt’s New Deal program and became a permanent measure in 1945. It gave tighter regulation of national banks to the Federal Reserve System; prohibited bank sales of Securities; and created the Federal Deposit Insurance Corporation (FDIC), which insures bank deposits with a pool of money appropriated from banks.
As it turned out, this was very sound legislation that significantly stabilized the U.S. banking system until its repeal in 1999. This was immediately followed by a wave of corporate scandals in 2001, unsound government home loan guarantee legislation that subsidized banks with taxpayer money in 2005 leading to the housing bubble of 2007, and an explosion in fraudulent financial securities and derivatives that led to Treasury Secretary Paulson’s extortion of a $700 million bailout from taxpayers for irresponsible behavior of his Wall Street colleagues.
A world in which there are a few big banks, rather than hundreds of small banks, leads to anti-trust collusion that governments have no way to control other than to exact fines. But that helps governments, not average citizens. It is very seldom, you see a government exact a fine and then reduces taxes, as governments themselves tend to display selfish behavior.
Protection of Private Property
The protection of life and property is the most fundamental principle of good government, as it is the foundation of economic prosperity and the willingness of people to save and invest in the future. Without such protections, it would be irrational for people the create wealth, only to have it stolen.
Public trust is not simply the faith people have in their government, it is also the faith people have in banks. Without trust that banks will keep their money safe, people will not use banks. The Glass-Steagall Act was a measure that encouraged public trust because banks were forbidden by law to speculate on stocks or otherwise gamble with money they held in trust for depositors. Sound banking is based on clear formulas of lending out money on deposit, with banks living on the interest margin between what is earned on loans and paid out on deposits. When banking is kept to banking and uninvolved with gambling, profits are nominal but the industry is secure.
The repeal of the Glass-Stegall Act in 1999 paved the way for the Citibank-Traveller’s Insurance merger and for banks to offer a wider array of services beyond traditional banking. This made banks more vulnerable to business cycles, but allowed them to speculate and accumulate large profits that could be used to bribe senators and Congress with lobby dollars to pass additional loan guarantees that would further enrich them and isolate them from the discipline of the market. Rhetoric was played to human compassion with statements that these guarantees would make housing available to those who could not afford it–the very people who were, in the end, exploited by this legislation. The government guarantees enabled banks to write loans that, in most cases, were guaranteed to fail without government bailouts. It only took a couple of years for these failures to pile up at the doorstep of FannieMae and FreddieMac, the federal mortgage backstop that had inadequate funds to underwrite free housing to millions uncreditworthy buyers. It also caused a price bubble that made property artificially expensive for responsible citizens.
The repeal of Glass-Steagall was a violation of the fundamental obligation of a state to protect private property, and by colluding with large banks, the state ended up undermining its own purpose and legitimacy. This was reflected in the extremely low trust in Washington political institutions and Congress the following decade. It was interesting for me to learn of Alan Greenspan’s shock and admission about the mistakes he had made at the Federal Reserve, especially his support the repeal of Glass-Steagall based on his libertarian ideology.
Markets and Big Banks vs. Small Banks
It is ironic that many people argue that large social institutions and bigger governments are more fair and less selfish. Why would a government want to prop up large banks and ignore the failure of small banks? Quite simply, large banks foster cronyism and support the desire of political leaders to stay in power. In return, political leaders provide them favors that allow them to escape from competition and pile up uncompetitive profits. It is easier to help someone you personally know. Small bankers, like the one Jimmy Stewart played in It’s a Wonderful Life, know individual townspeople, large bankers know the people they hang out with. It is human nature to seek to please people you are close to, and care less about those we cannot see.
Large social institutions are impersonal in nature. You never see the person who issues your passport. When rules are clear and fair, and the person issuing the passport follows them, citizens trust the bureaucracy. However, if those who issued passports would discriminate against people on the basis of race, religion, gender, or wealth, that bureaucracy would forfeit its trustworthiness and lawsuits would be filed. Large banks and governments are the same in this way. Banks hold citizen’s money in trust, and thus it is a public trust. Glass-Stegall was one mechanism that fostered that trust.
Markets also foster trust, because firms that fail to provide trust simply go out of business. But, free markets require competition and bigness works against it. When Adam Smith wrote about free markets, he envisioned each household or family business as an economic cell. The economy would be widely spread across the entire population, with each competing to serve the needs of their family. Inbuilt in families is the very personal nature of relationships and a natural desire to care for one’s children, elderly, and extended family. Profits, when realized by a family, tend to involve a measure of unselfishness because it is very hard to live in close quarters with someone one loves and not “share the wealth.”
Large banks and other financial institutions, because of their impersonal and bureaucratic nature, are incapable of such unselfishness. Like machines, they simply obey the principles of their existence. In the case of economic enterprises like banks the goal is profit for shareholders. There is no place for stewardship or welfare in the maximization of their goals–only a desire to change laws so more profit can be made. This is why large institutions must be regulated in ways that are different from individuals. Glass-Steagall forced banks to live within the principles of sound banking, only lending money that was on deposit. Profit, in that case, could not come from speculation, but only from greater management efficiency and better lending practices that enabled them to compete against other banks in providing the best service.
The repeal of Glass-Steagall happened under Greenspan’s watch, with a Democratic President, Bill Clinton, and with a Republican Congress led by Newt Gingrich. All three of these signed on to this unwholesome legislation, so we can’t blame just the Federal Reserve, or the Democrats, or the Republicans. All of them failed to learn from the lessons of history and bet our nation’s prosperity on mythical wishes that unregulated bureaucracies would save the economy. We saw the results of a culture that had become disconnected from sound principles. And the arguments between the two political parties tend to distract people from the central weaknesses of both.
Markets are important because they lead to win-win results for producers and buyers, whereas government reallocation of goods is always win-lose. However, markets need regulation, and particularly economic consolidation and size has many problems our leaders are unwilling to point out, because they profit from it at the expense of citizens. A local banker will drive by a property and see how the borrower cares for the property he loaned money on. A Citi-banker in New York only has a credit score and application forms and has no proof a property even exists except for what his papers tell him. Good stewardship is impossible in that case, and large bureaucracies easily perpetuate fraud and are easily defrauded. In my view, economic consolidation has removed a sense of ownership from individuals and families and turned them into workers seeking jobs from a large system — a new type of industrial serf, rather than a foundational unit of society.
When the big banks failed, a principled government would have dispersed the assets of those banks among small banks, rather then letting them consolidate further. Instead, the irresponsible big banks were bailed out and the small banks, who were casualties of the misdeeds of the large ones, were allowed fail. Dodd-Frank was an example of cronyism at its zenith, rather than principle, and the end result is worse than the the situation that led to the crisis. The answer should have been the full reinstallation of Glass-Steagall. Instead we have today’s headlines:
BRUSSELS (Reuters) – EU antitrust regulators fined six financial institutions including Deutsche Bank, Royal Bank of Scotland and Citigroup a record total of 1.71 billion euros ($2.3 billion) on Wednesday for rigging financial benchmarks.