Repeal of Glass-Steagall: Not a cause, but a multiplier

When the Titanic set sail from Southampton on April 10, 1912, bound for New York, it was called “unsinkable.” This was before that chance encounter in the North Atlantic with a large iceberg. You know how that movie ended.

Many people died, of course, because there were too few lifeboats. But even if the luxury liner had four times as many, the Titanic still would have ended up on the bottom of the ocean, done in by a captain more concerned with speed than safety — and that iceberg.

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This simple reality, however, obscures a broader truth.

Before it sank, more than 700 passengers loaded onto the 20 lifeboats on board and escaped with their lives. More than 1,500 others died. The Titanic had the capacity for 64 lifeboats, which could each hold 65 people. Fully loaded, they could have carried more than 4,000 to safety — or every man, woman and child aboard. Thus, many more could have survived.

While the shortage of lifeboats didn’t cause the sinking, this insufficiency after the crash was a factor in the 1,502 deaths.

I was reminded of this recently after reading articles that argued over the role the repeal of the Glass-Steagall Act played in the financial crisis. The Depression-era regulation that separated Main Street banks from Wall Street investment firms had a huge impact on the finance sector.

The repeal of Glass-Steagall may not have caused the crisis — but its repeal was a factor that made it much worse. And it was a continuum of the radical deregulation movement. This philosophy incorrectly held that banks could regulate themselves, that government had no place in overseeing finance and that the free market works best when left alone. This belief system manifested itself in damaging ways, including eliminating regulation and oversight on derivatives, allowing exemptions for excess leverage rules for a handful of players and creating dangerous legislation.

As the events of 2007 to 2009 have revealed, this erroneous belief system was a major factor leading to the credit boom and bust, as well as the financial collapse.

I have been unable to find any evidence that the Gramm-Leach-Bliley Act — the legislation that repealed Glass-Steagall — was a primary cause of the financial crisis. Imagine a “but for” scenario where Glass-Steagall had not been overturned but the rest of the deregulatory actions had still taken place. Would the crisis have occurred? Without a doubt, yes.

The Fed still would have taken rates down to unprecedented low levels. This would have led to a global spiral in asset prices. The nonbank, lend-to-sell-to-securitizer mortgage originators were still going to make subprime-mortgage loans to unqualified borrowers. Bear Stearns and Lehman Brothers would still have overwhelmingly increased exposure to subprime mortgages. AIG would still have written trillions of dollars in credit-default swaps and other derivatives with zero reserves set against them. The largest security firms and deposit banks would still have charged headlong into the subprime securitization business. And Fannie Mae and Freddie Mac would still have belatedly chased these banks into the same subprime market, just at the peak of the housing boom.