does it make sense to resurrect the Glass-Steagall act?
The Myth of Financial Deregulation
Prior to the financial deregulation of the 1980s, we had controlled banking. Banks’ conduct was guided by the central bank. Within this type of environment, banks’ profit margins were nearly predetermined, because the Fed imposed interest-rate ceilings and controlled short-term interest rates. Hence, the life of the banks was quite easy, albeit boring.
The introduction of financial deregulations and the dismantling of the Glass-Steagall Act changed all that. The deregulated environment resulted in fierce competition between banks.
The previously fixed margins were severely curtailed. This in turn called for an increase in volumes of lending in order to maintain the level of profits.
This increase culminated in an explosion in the creation of credit out of thin air. Indeed, in the deregulated environment, banks’ ability to amplify the Fed’s pumping has enormously increased.
Note that the AMS-to-trend ratio hovered very close to 1.0 from 1959 to 1979. Since the early 1980s, this ratio has been rising visibly, climbing to 1.77 by November 2008.
We suggest that it is this massive explosion of money that has severely damaged the pool of real savings and laid the foundation for the present economic crisis. Rather than promoting an efficient allocation of real savings, the current “deregulated” monetary system has been channeling money created out of thin air across the economy.
From this it follows that in the present banking system, what is required to reduce a further weakening of the real-wealth-generation process is to introduce tighter controls on banks.
As Murray Rothbard put it,
Many free-market advocates wonder: why is it that I am a champion of free markets, privatization, and deregulation everywhere else, but not in the banking system? The answer should now be clear: Banking is not a legitimate industry, providing legitimate service, so long as it continues to be a system of fractional-reserve banking: that is, the fraudulent making of contracts that it is impossible to honor.
Pay attention that we don’t suggest suppressing the free market, but suppressing banks’ ability to generate credit out of thin air. The present banking system has nothing to do with a true free-market economy.
It must be reiterated here that more controls in the framework of central banking can only slow down the pace of the erosion of real-wealth formation. They cannot prevent the erosion. (Remember, the Fed continues to pump money to navigate the economy). More controls will simply suppress banks’ ability to amplify the Fed’s pumping. In this sense, controls are preferable to a so-called deregulated banking sector.
Would more controls, i.e., keeping the Glass-Steagall Act intact, have prevented the current economic crisis? We suggest that the crisis wouldn’t have been as severe, since controls would have prevented the massive monetary explosion since the early 1980s, which put the pool of real savings under severe pressure.
The financial deregulations have sped up the erosion of the real-wealth-generation process. Consequently, instead of having a severe crisis in 20 years’ time, we have it now.
As you already know, the pre-midterm election/post Massachusetts election get tough on Wall Street and the banks official Administration policy is now in play. Maybe. Sort of. Well, we’ll see. At least it was a short term sound bite the Street took seriously for about 3 seconds at this point. Conveniently attention has been diverted by Greece and friends. Whether it’s all for show or will really have teeth somewhere down the road is the question to be answered. Nothing “x” millions in campaign contributions can’t derail, no? The real issue is not the potential for separation in trading versus lending operations for the banks, but a much, much larger issue lies dead ahead if the Administration is really serious and simply not creating a perceptual show. (At least so far they get an A+ for creating very short term perceptual shows.) The big issue once again comes back to leverage. Here’s the deal. Despite the hurt meted out by the equity markets in 2007 and 2008, prop desk trading was the saving grace for financial institutions last year. And of course this prop desk trading was “facilitated” by cheap money from the Fed/Treasury/Administration. Additionally, and without question, the use of leverage at the prop desk level is more than alive and well. Point blank, one bubble that is still thoroughly alive and well is leverage. One of the few glimpses we get of this is looking at the banking system derivatives data. So here’s the question for you to ponder. IF the Administration is really serious about separating prop trading from commercial banking, will the process set off yet another massive wave of deleveraging? Let’s face it, if prop desks are essentially to be cut asunder someday from Government bailouts and taxpayer support, will they adjust their use of leverage to account for this new set of circumstances? And this is surely what has in part spooked the equity markets in recent weeks. Although short attention span theater on the Street is a reality.