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Home Publications Blogs Beat the Press Glass-Steagall and the Economic Crisis

Glass-Steagall and the Economic Crisis

Monday, 21 May 2012 21:47

Andrew Ross Sorkin seems to be very proud of himself for having figured out that Glass-Steagall would not have prevented the economic crisis that hit the economy in 2007 and is still causing tens of millions of people to be out of work or underemployed today. He is of course right, except most of us knew this 4 years ago.

The crisis, which is an "economic crisis" not a "financial crisis" was caused by the collapse of an $8 trillion housing bubble. This bubble was driving the economy by sparking both a construction boom and a consumption boom. When house prices came back down to earth, these sources of demand evaporated and there was nothing to replace them. It's a fairly simple story for those of us who learned arithmetic back in third grade.

Glass-Steagall played no direct role in the crisis or the buildup to it. Nonetheless, it does get to heart of one of the big unnecessary freebies that the government gives to the financial sector. The point of the law was that if you held government-guaranteed deposits then there should be restraints on the sort of risks you can take.

It is understandable that the spoiled brats who run big banks on Wall Street think that they should be able to get handouts from the government with no strings attached, but that is not the way a market economy is supposed to work. If the banks don't want the government's guarantees for its deposits, no one is forcing them to take the guarantee. But, if they take the guarantee, then they don't get to take big risks like Jamie Dimon's big bet.

This tradeoff is pretty straightforward. Even an NYT business columnist should be able to figure it out. 

Comments (14)Add Comment
Deregulation contributed to the housing bubble
written by Dan Lynch, May 21, 2012 10:12
Banks were deliberately sloppy or even fraudulent with mortgage apps because they knew they were going to unload the mortgage on someone else. Perhaps not Glass-Steagall per se, but the end of the New Deal banking regulations created an environment where bundled mortgages were traded like pork bellies.
Work 4 Gov't Handout?
written by James, May 21, 2012 11:59
For years now, GOPs and Fox News have clamored that people such as single mom (without any day care help)need to work for their meager gov't assistance. As the eloquent Bachman lectured us, "you don't work, you don't get to eat."

For the Big Boys to work or give up something for the still TBTF benefits, it WILL never happen!

Just like now JPM Chase is still only down 18% and beating bc investors know it: they are too big and gov't will bail them out again. Just that perception itself already temepers their fall.

Picture if a community or regional bank has bet as big a % of their capital on any type of risky inv't, they would have been gone - rip to pieces by investors.

Case in point - IndyMac was of course engaged in very risky, Alt-A, No Doc Loans, but what triggered them was what? Essentially one letter and investors know no one was coming to the rescue.
written by Andrew Clearfield, May 22, 2012 12:20
What a weird response to a bland, accurate, and (seemingly) uncontroversial column. Sorkin says Glass Steagall is good but wouldn't have stopped the financial crisis; who (besides apparently you)could possibly find fault with those claims? (And yes I say "financial" crisis because that's what it was: when the world banking sector is so messed up that it makes zillions of dollars in bad housing loans, repackaging them and so on so that a housing bubble in a few areas can bring down the world economy, that is quite properly called a financial crisis.)
Tulips, Houses and Derivatives
written by Robert Salzberg, May 22, 2012 4:40
  The economy was driven by the housing bubble but the housing bubble was the direct result of massive fraud and incompetence in the financial sector made possible by massive incompetence in government regulation.

    There never should have been loans issued by government insured banks  without verifying income and it was illegal to call them conforming loans and pass them along to Fannie and Freddie. 

    Ratings agencies were and are over rated in their ability to assess risk.

    The derivatives market, which in theory is a way to hedge risk, did and does represent the greatest clear and present danger to the banking system, the financial system and world economies.

    The scale of the derivatives market is largely unknown and unknowable to this day because of continued opacity but has been estimated as being 4-6 hundred trillion dollars. 

    Asset bubbles in general and the housing bubble in particular generally hide in plain sight and can be controlled if governments properly regulate commerce. 

   Strict enforcement of existing regulations would have prevented liar loans from being more than a miniscule problem for Fannie and Freddie and for government insured banks. There would have been no housing bubble if people weren't loaned more money than they could be expected to pay back.  The FED should have recognized early on that the steep housing price rise was not based on fundamentals and acted accordingly.  Decent regulation of the rating agencies would have kept mortgage backed securities that were comprised of subprime loans from having AAA ratings. 

    In short, all the causes of the housing bubble were financial in nature.  The tulip craze crashed world economies.  Should we call that a tulip crisis or an economic crisis or a financial crisis?

    In the final analysis, what matters most is not the semantics, but whether humanity as a whole learns from it's financial mistakes.  Considering the world has spent the last few years dominated by governments that are pushing austerity in a liquidity trap which exactly matches the fundamental preventable error committed in the Great Depression leads a sane person to answer no.
written by kharris, May 22, 2012 7:45
Andrew C has nailed Dean pretty squarely.

Dean is, again, relying on a false dichotomy. I can only guess that his tendency toward over-simplification (false dichotomy is a form of over-simplification) is in service of his role as pundit, rather than as economist, because insisting that our economic trouble is just a demand shortage and so is not a financial problem, is bad economics.

The overnight lending market in the US froze up after Lehman's collapse. Longer-term credit was already a problem, but the problem became a crisis when Lehman created a payment crater. The history of the matter is that economic recovery after a credit crunch is slower than without a credit crunch. As far as I'm aware, this isn't even controversial. So to insist on ignoring the financial element of our current situation is to insist on ignoring important economic factors.

We do have a demand shortage. That does not mean we didn't have a credit crunch. Suggesting that one excludes the other is bad thinking, and bad economics.
written by David, May 22, 2012 8:25
A college education is supposed to teach students the difference between critical thinking (Baker) and merely being critical (Clearfield). Perhaps the reason that Dr. B's critique seems "weird" to Mr. C is not that it its actually weird but that understanding requires thinking. People don't like thinking, and they're not good at it, and they won't do it if they can possibly avoid it. Nonetheless actual thinking is necessary. Now, re-read Dr. B's critique (it's clear that Clearfield did not do so), where he clearly states what Sorkin's article fails to mention, the essential raison d'etre for having Glass-Steagall (Sorkin criticizes Ms. Warren for historical revisionism but does so himself; that is the point).
written by skeptonomist, May 22, 2012 9:03
The headline to Sorkin's piece says "Reinstating an Old Rule Is Not a Cure for Crisis". But it is an essential part of the cure. The financial system is so rotten that a single reform will not give a risk-free system, but that is not an excuse for not doing any single piece of the reform. It is actually quite likely that things would have been very different if all of Glass-Steagall had still been in effect (parts of it had been weakened before the formal repeal of commercial/investment separation). Commercial banks would probably have been much less likely to engage in risky behavior. Nothing has changed to make separation of commercial and investment banking less necessary than it was in 1933; bankers and financiers are not any smarter and they have demonstrated that they don't learn from history.

Sorkin's piece is an attack on a straw man; nobody has said that reinstating Glass-Steagall "is the ultimate solution".

written by Burton, May 22, 2012 10:28
I generally really love Deans blog and consider it part of my daily activity of staying informed.

I think he's too hard on Sorkin here. Sorkin starts by making the point that a meme exists which states "the end of Glass-Steagall caused the financial crisis". This is accurate, and to see this directly watch: "The inside Job" which makes this link pretty explicit. I think it would be a failure of the progressive movement to ignore it's own blind spots. Sorkin calling out a blind spot is not a bad thing.
written by jeffn, May 22, 2012 11:28
I think Dean is pointing out the overall uselessness of Sorkin's article. Is it really helpful to discuss what a previous law may or may not have done during this financial crisis? I don't think anyone is disputing the need for reform in the banking sector, the question is what form it should take. I don't believe a bank (or bank holding company or whatever they are now) has any need to engage in these kinds of risky behaviors. North Dakota, the only state who owns its bank, has emerged from this crisis with the lowest unemployment rates and high growth as well, I don't think thats a coincidence. If you want to bet on derivatives, sovereign debt, or the damn Yankees, go ahead, but with your own money on the line. The benefits of this absurd financialization our economy has witnessed over the past few decades far outweigh the risks. Lets focus our energy on creating something REAL, instead of developing a trading algorithm that screws your competitor over .0001 seconds faster than he can screw you.
But Glass-Steagal should be reinstituted anyways ...
written by Benedict@Large, May 22, 2012 1:15
I completely agree that the loss of Glass-Steagall didn't cause the crisis. It's loss however made any recovery far more difficult, as it wed policymakers with the TBTF banks, making those policymakers far more fearful that a loss of any of them might collapse the system.
Good & Bad Times
written by Calgacus, May 22, 2012 9:34
Glass-Steagall & zealous enforcement would have made blowing the bubble a bit harder in the first place. Would have made financial fragility clearer & less dangerous, earlier. The financial crisis ending the bubble caused an economic (unemployment, output gap, poverty) crisis & was in turn caused by earlier economic crises and their mismanagement. The abandonment of full employment & economics that made any sense or had anything to do with reality in the 70s underlay it all.

In other words, people who watched their TVs back in the 3rd grade while learning arithmetic understand how fragile good times from living on easy credit ripoffs after temporary lay offs are.
Name Doesn't Matter
written by James, May 23, 2012 10:00
whether it's called Glass-Steagall, SOX, and the latest one Dodd-Frank, one of the main theme is if the big boys, smartest guys in the room with Ivy-league MBA's should yield to a modicum of oversight if they are enjoying and benefiting gov't subsidy in the form of insured deposits.

Should they?

It was not long ago that we didn't have GM or investment firms owning financial institutions.
McFadden Act Too!
written by leo from chicago, May 25, 2012 9:51
It's all well and good to look back with nostalgia at the Glass-Steagall Act but it's also important to remember that other guardian of fiscal stability/sanity, the McFadden Act.

statistical abstract facts contradict Baker
written by Ben Leet, May 31, 2012 7:38
A quick look at the Statistical Abstract, Table 722 shows a drop in net worth to the nation of $13 trillion years 2007-2008. $9 trillion was a drop in financial assets, $3 trillion were in household real estate. It was a financial crisis. Still is. Others have said the same. Arguing that eliminating Glass Steagall created the crisis does not follow. TBTF and all the CDO sales that lifted banks out of liability for the bad debt they were facilitating made the crisis.

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.