Bring Back Glass-Steagall

Posted June 08, 2010, at 7:33 p.m.

Back in 1933, when the United States was working its way out of the Great Depression, a wise and courageous Congress passed the Glass-Steagall Act. It erected a firewall separating the banks from Wall Street, thus protecting investors, taxpayers and the financial system as a whole against the secretive speculation that had led to economic collapse.

In 1999, a less wise and less courageous Congress, swept up in a fad for deregulation, repealed Glass-Steagall. President Bill Clinton signed the repeal bill. Destroying the firewall was part of a binge that freed electric power production, airline service and telephone service from government regulation — all in the fixed belief that free markets, not government supervision, always will know best.

The repeal helped fuel the financial boom through the first George W. Bush administration, with the widespread belief that real estate values and the stock market would keep rising indefinitely. Investment banks, freed of the close regulation of commercial banks, could speculate in complex investment products with borrowed capital that multiplied gains (and losses) 30 times or more. They encouraged excesses such as subprime mortgages granted with enticing features including variable rates, no down payment and an interest-only or interest-free period.

Most economists went along with this rosy scenario, but not quite all of them. Nauriel Roubini, a New York University economics professor, long had believed that economic disasters were inevitable and predictable. He predicted this one while financial leaders still were reassuring the country that the markets were self-regulating and secure. He shocked a skeptical audience at the International Monetary Fund in Washington, D.C., in September 2006 by warning of an impending housing bust, oil shock, loss of consumer confidence and a deep recession.

The book he co-wrote in 2010, “Crisis Economics: A Crash Course in the Future of Finance,” said that the repeal of Glass-Steagall opened the way for a series of mergers among investment banks, commercial banks and insurers and led the way to the growth of an unregulated system of complex derivative securities that boomed and finally collapsed.

To repair the damage and minimize future crises, he recommends, among other remedies, the resurrection of Glass-Steagall, while updating it to meet new challenges posed by the banks and by what he calls a “shadow banking system” of largely unregulated hedge funds, investment banks, insurers and money market funds.

Unfortunately, neither of the House and Senate financial reform bills includes this vital provision. In reconciling the two bills, lawmakers should defy the objections of the big bankers and adopt an amendment to reinstate Glass-Steagall.

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