The New Neo

Most of us are unfamiliar with the details of the world of finance that led us into the current crisis. Except for those in the business, whoever heard of tranches and derivatives, of the uptick rule and the quants, until recently?

Certainly not me. And not most of us, either. So how are we voters to evaluate whether any of the Obama administration’s solutions are likely to help or hurt? Especially when the supposed experts disagree?

As with all complex systems, the worldwide economy is difficult to understand and virtually impossible to control. We try to intervene in certain ways and come up against the fact that we probably haven’t identified most of the variables involved. The law of unintended consequences continues to rear its ugly little head.

And yet it’s crisis, crisis, crisis, so something must be done—right? The option of doing nothing—or doing less—and letting matters run their course seems so very passive.

In this crisis, people tend to see what they’re looking to see. Those who are laissez-faire capitalists can point to government regulation that backfired and helped lead to the current problems. Those who want government to intervene more can point to areas where uncontrolled profit-hungry capitalists chose short-term gain and sacrificed long-term stability.

Ever since September, I’ve had to give myself a crash course in finance. My knowledge of these things is still rather spotty to say the least, but I have come to the conclusion that the problem is not too much or too little regulation per se, but regulation of the wrong type, plus the difficulty of figuring out what the right type would be.

For example, take Glass-Steagall. When it was repealed in 1999, I certainly didn’t notice—did you? I only first learned a bit about it this September, right at the beginning of the crisis, when people said that the bill’s repeal was part of the reason the current meltdown happened. Many said that if the Glass-Steagall firewall between investment and commercial banks enacted during the Great Depression had remained in place, it would have protected us from the magnitude of the crisis.

I hadn’t heard much about Glass-Steagall since, and I was wondering what had happened to the idea of putting some version of it back in place. When I Googled “bring back Glass-Steagall,” I discovered that Paul Volcker had recently suggested doing just that.

Who was in favor of repealing Glass-Steagall in the first place, and why? It turns out that it was a hugely popular and bipartisan decision, although there was a small minority against it. That minority happened to have been mostly, although not entirely, composed of Democrats.

The votes were as follows: 90 to 8 in the Senate and 362 to 57 in the House. The bill’s passage was highly praised by none other than Larry Summers, who was then Clinton’s Treasury Secretary. It was considered to be a move for modernization, a casting off of old shackles that were no longer needed.

There were a few voices of warning. But there was no reason to believe they were anything but fearmongering by those too backward-thinking to enter the Brave New World of modern finance (the following is from a NY Times article written in 1999):

The opponents of the measure gloomily predicted that by unshackling banks and enabling them to move more freely into new kinds of financial activities, the new law could lead to an economic crisis down the road when the marketplace is no longer growing briskly.

”I think we will look back in 10 years’ time and say we should not have done this but we did because we forgot the lessons of the past, and that that which is true in the 1930’s is true in 2010,” said Senator Byron L. Dorgan, Democrat of North Dakota. ”I wasn’t around during the 1930’s or the debate over Glass-Steagall. But I was here in the early 1980’s when it was decided to allow the expansion of savings and loans. We have now decided in the name of modernization to forget the lessons of the past, of safety and of soundness.”

Note that Senator Dorgan even gets the time-frame eerily right: “I think we will look back in ten years’ time…”. It doesn’t sound so very backward-looking today, does it?—unless looking at history can be considered backward-looking. If so, count me in as being backwards.

Ah, but if only it were so simple. Many people, Volcker included, think that Glass-Steagall should be reinstated in some manner. But there’s by no means agreement on that, even today, and the details of what might be necessary are unclear as well. You see, there were valid reasons the bill was repealed and that it had such strong bipartisan support. Here are a few, from the same contemporaneous Times article (note that the people talking it up are Democrats, as well):

Supporters of the legislation rejected those arguments. They responded that historians and economists have concluded that the Glass-Steagall Act was not the correct response to the banking crisis because it was the failure of the Federal Reserve in carrying out monetary policy, not speculation in the stock market, that caused the collapse of 11,000 banks. If anything, the supporters said, the new law will give financial companies the ability to diversify and therefore reduce their risks. The new law, they said, will also give regulators new tools to supervise shaky institutions.

”If we don’t pass this bill, we could find London or Frankfurt or years down the road Shanghai becoming the financial capital of the world,” said Senator Charles E. Schumer, Democrat of New York. ”There are many reasons for this bill, but first and foremost is to ensure that U.S. financial firms remain competitive.”

Kerrey’s statement seems laughable today, of course, but that’s only with the benefit of hindsight. It is Schumer’s that is more important: the bill was seen as necessary to keep up with the rest of the world. Perhaps it was, at the time.

The real question for us today—probably as unanswerable as ever—is whether the repeal of Glass-Steagall really was instrumental in causing the current crisis, and whether its reinstatement would help to prevent future ones from occurring. Here’s one “expert” who disagrees with Volcker and says it wouldn’t make a bit of difference:

Glass-Steagall would not have stopped the current crisis. For starters, many institutions that have had trouble were not commercial banks. Lehman Brothers, Bear Stearns and Merrill Lynch were investment banks; the American International Group is an insurance company…Any institution that is too big to fail, even if it is not in the utility end of banking, requires some sort of regulation.

So the solution is not to pick on one particular banking activity ”” like proprietary trading ”” label it as risky and quarantine it in some half-regulated purgatory. The better approach is to improve risk management across the industry.

I’m no banker, but it seems to me it’s not an either/or proposition. Why not reinstate some form of Glass-Steagall, and also change the leverage requirements so that they resemble the more stringent ones of yesteryear? After all, since most of the world has gone down with us, the competition is no longer as fierce.

Yes, the result would be that we wouldn’t have the astronomical growth we had during the last decade. But since that growth has turned out to be a bubble, wouldn’t that be a good thing?