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Shoot Yourself in the (Glass) Foot? Blame a Guy Named Steagall.

March 2, 2010

Eugene White, one of the greatest economic historians I can think of, tells the story of Glass-Stegall. Also in this series, and by a guy named White: check out Larry White’s EconTalk podcast regarding Smoot-Hawley and the Great Depression.

Highlights of the article:

Glass believed in the old and discredited “real bills” doctrine that banks would be completely safe if they could be restricted to very short-term commercial lending. Any other banking activities, including investment banking, he deemed an inherent threat. While the administration and all experts argued that the securities affiliates should be brought under supervision of existing regulators to manage any problems, Glass insisted that there would be no legislation unless there was a radical and complete separation of commercial and investment banking.

The “real bills doctrine”, in a nutshell, is a theory that states that as long as a bank issued currency (in the form of loans) discounted based on net present value of collateral (like a farmer’s wheat harvest), then the issuance of currency would not be inflationary. Of course, stand-alone investment banks of the day were more than happy to stand behind Carter Glass, and be shielded from competition by commercial banks.

A friend of the thousands of tiny banks that dominated the banking landscape of the time, Steagall pushed forward their agenda. These inefficient small and overwhelmingly single office institutions were far from diversified and had suffered terribly in the banking crises. They opposed branching and expansion of the large banks and sought legislation for deposit insurance, viewing it as a means to reassure their depositors who might otherwise flee to the safety of a bigger bank.

Ahh, a man backed by a special interest. Sounds practically alien! On a deeper note, there is a pernicious fallacy among the left that leads them to believe that the only “proper institutions” are “small business”. A rather explicit example comes from William Greider, the economics “specialist” at The Nation, writing in his book; The Soul of Capitalism. To paraphrase, Greider notes that most job growth in the US comes from privately-held “small businesses”. During the 90′s, Fortune 500 companies reduced employment by 4%, while privately held firms increased employment by 20%. Seeing this, he concludes, “if more American capital flowed into the smaller enterprises and less to larger ones, the economy would not suffer, but benefit.”

Do you see what he did? Fortune 500 companies didn’t reduce output, they reduced employment, by shifting toward more capital-intensive investment (like…the internet!). Greider (and politicians, and Henry Steagall) recommended (recommends?) that capital be shifted out of highly productive sectors, and into less productive ones — ostensibly to increase employment. That, of course, is not the objective of economic activity. The objective is to create wealth efficiently.

The physical laws that govern the formation and operation of networks and information non-withstanding, the most efficient form of production ever would be a single, giant firm producing everything in the economy at marginal cost. That was the point of communism. Unfortunately, reality.

To conclude, some fun with a paragraph!

Some of the bankers who faced chief counsel Ferdinand Pecora Phil Angelides had been guilty of certain crimes. But not all; and in fact, the true indictment was the whole industry had caused the Great Depression Recession. The public and media have commonly assumed that they were convicted of this “crime” in the hearings. But again careful scholarship (including the work of Milton Friedman, Anna Schwartz, Ben Bernanke, and Christina Romer Robert Hetzel, Scott Sumner, Bill Woolsey, and Lars Svennson) has established that the primary cause of the Great Depression Recession were the faulty policies of the Federal Reserve.

Like a broken clock. There is literally no evidence that divided banking results in safer, or more prudent banking…or a more resilient banking system. In fact, the US had a more resilient banking system going into the Great Depression (in the absence of deposit insurance).

Update: Over at VoxEU, Hans Werner-Sinn has an article pleading the EU not to adopt separated banking. Unfortunately, he mis-identifies the case of the crisis, but it’s a good article anyway!

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For more reading about the history of Glass-Steagall, and the (sham) Peacora Hearings, read Alex Tabarrok.

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