Was repealing Glass-Steagall the cause for the present Depression?

There is a view making the rounds now that repealing the Glass-Steagall Act of 1933 is the root cause for all of the excesses we have experienced — and by extension for the present economic Depression.  Glass-Steagall was enacted in 1933 in the first Great Depression in order to prevent many of the abuses we have witnessed in the past 10 years by separating commercial banking from investment banking and securities firms. The logic here is that conflicts of interest were held in check before the Depression-era Glass-Steagall Act was repealed by the Graham-Leach-Biley Act of 1999.  After Graham-Leach-Biley, the financial sector ran amok, leveraged up and generally went into irrational exuberance mode.  The financial sector now lies in tatters and another global Depression has begun.  Therefore, we need to re-institute Glass-Steagall, lest we suffer another Depression in the future.

I don’t buy this line of argument for a second.  The fact of the matter is the universal banking model which Glass-Steagall ended has always been in existence in nearly every other modern industrialized nation both before and after the Great Depression.  There is zero connection between the universal banking model and this Depression.  But, that doesn’t stop many from putting forward this argument.

In The Nation, Robert Scheer says the following:

The reversal of Glass-Steagall unleashed the robber barons, as was freely conceded by Goldman CEO Blankfein in an interview he gave to the New York Times in June of 2007. “If you take an historical perspective,” Blankfein said, gloating back then about the vast expansion of Goldman Sachs, “We’ve come full circle, because that is exactly what the Rothchilds or J.P. Morgan the banker were doing in their heyday. What caused an aberration was the Glass-Steagall Act.”

The “aberration” being the sensible regulation of Wall Street to prevent another depression, which now seems dangerously close at hand. Since Glass-Steagall was repealed in 1999, Goldman Sachs experienced a 265 percent growth in its balance sheet, totaling $1 trillion in 2007.

What we need is an honest accounting of how we got into this mess, beginning with an investigation of the role of Goldman Sachs as the most insidious Wall Street player. But we are not likely to get that from an administration populated by Goldman’s Washington allies.

While, the article is principally concerned with the question of conflicts of interest at Goldman Sachs, Scheer is clearly taking aim at the repeal of Glass-Steagall. He has the wrong target altogether. Deregulation is the problem, not Glass-Steagall.

Before the Great Depression, the United States had what is known as the universal banking model. This allowed financial institutions to take deposits, lend funds, issue securities, and arrange merger transactions all under one roof. The problem with this model is that there are inherent conflicts of interest. So, in the 1920s, we saw institutions flogging the shares of companies for whom they issued securities to their depositors. Many of these companies were of dubious quality and were deep in debt to the same institutions. So the banks obviously had every incentive to reduce exposure and heap the burden onto their own depositors. These abuses were uncovered after the stock market crashed in 1929 and the Great Depression began, eventually leading to the Glass-Steagall Act of 1933.

Meanwhile, in Europe there was a Depression in the1930s as well. However, banks continued operating in the universal banking model in countries like France, Germany and Switzerland without interruption. None of these countries suffered depressionary collapses in the years since the Great Depression. Clearly, the universal banking model is not the source of the problem then.

The real problem is deregulation — and this is where the Scheer article is on target because many of the proponents of the disastrous deregulation of the 1990s are in the new Obama Administration making policy decisions. I have deep misgivings about the quality of their banking crisis solution given their prior failings and the degree to which firms like Goldman Sachs have ingratiated themselves into economic policy. But, that is a topic for another time.

Here, I am discussing deregulation and the origins of the deregulation movement. After the Reagan-Thatcher revolution, fans of deregulation and the efficient market hypothesis gained sway in economic policy circles. The idea, particularly in the United States and Britain, was that government was a burden suffocating business with regulation. Reducing the burden by de-regulating would free business and financial markets to operate more efficiently, creating benefits for everyone.

The problem with this ideology is that deregulation  usually means irrational exuberance and turmoil for the deregulated market. For example, in Sweden, the housing bubble that preceded their banking system failure and nationalization was preceded by deregulation. In the United States, immediately after the airlines were deregulated, the industry experienced turmoil and repeated bankruptcy. After the financial services deregulation in the U.K in 1986, irrational exuberance led to scandals and a housing bubble which crashed spectacularly in the early 1990s.

Deregulation is a term used at once to mean reduced regulation and reduced oversight. But, oversight will always be necessary, particularly in markets newly open to competition. In the United States, companies within the financial services industry were allowed to enter new markets after 1999 without sufficient regulatory oversight. There is nothing wrong with JPMorgan Chase issuing securities, practicing investment banking, lending money and taking deposits as long as the regulators are there to prevent conflicts of interest and excess.

With easy money from low interest rates as an elixir, irrational exuberance begins to make financial services firms drunk with greed. It should be expected that some are going to cross the line. And that’s where vigilance is needed: to prevent predatory lending, excess leverage, off-balance sheet investment vehicles, and enormous OTC derivatives exposure. These are the excesses of the last decade. They have nothing to do with Glass-Steagall and everything to do with deregulation.

Wall Street in Washington – The Nation
Regulation – Wikipedia
Big Bang (financial markets) – Wikipedia
Repealing Glass-Steagall: The Past Points the Way to the Future – Federal Reserve Bank of Philadelphia, 1996

  1. Tom Lindmark says

    I agree with almost all of your comments. I agree that Glass-Steagall didn’t cause the problem but would ask one question. Did it encourage the growth of overly large banking conglomerates that were unmanageable and by the very nature of their size ensure that if they ran into trouble there was no option except a bailout? The follow-on question, then is should we aim to have smaller financial institutions that are more specialized?

    1. Edward Harrison says

      Good question, Tom. Here’s my take. I would love to hear your response. I would say that bank size is a regulatory issue. There is nothing wrong with the Fed telling a bank that it is too large and needs to cut its asset size. The Federal Reserve and the SEC have many more regulatory powers than they have exercised in the past 10 years. No new regulation is needed. Regulators need to enforce the laws already available. The Madoff case is a perfect example of how the SEC did not enforce the laws already on the books. And the enormous size of JPMorgan Chase and Citigroup is an example of deals that went through which could have been resisted on anti-trust grounds.

  2. Tom Lindmark says

    I would have no problem with the issue of size being attacked through regulation. I do think that you have to lay down some sort of comprehensive set of guidelines within which financial institutions will operate. There has to be some road map otherwise no one will invest in them. So in that sense the regulators would have to make it pretty clear exactly how the institutions will be allowed to grow and what activities they will be allowed to participate in.

    I agree completely that we don’t need much new regulation. Enforcement of existing regulation would have gone a long way towards preventing some of the issues we currently face. I might add that this failure of enforcement occurred at the state level as well as the federal level. A large part of the problem, in my opinion, is under funding the regulatory apparatus at all levels. It’s no secret that the odds of getting caught are so small that it’s wotrh the risk if the payoff is large enough.

  3. Econophile says

    Oh my, Edward. You really have slid pretty far down the slippery slope. As a former Austrian, you know what my argument is going to be: “deregulation” as you call it, was not deregulation. The financial market is one of the most regulated of all industries. It’s nice to know that you feel that some regulator out there has the wisdom to know what the “right size” of any bank should be. What about the Law of Unintended Consequences which is what we are currently suffering from as the result of regulation, political influence in regulation, and a Fed run amok.

    One last comment. The airlines? All their bankruptcies? Are you suggesting we should go back to the cartels and high ticket prices? Not very “free market” of you.

  4. Edward Harrison says


    I still believe in the free market. In fact, that’s why I am arguing 1. Against Glass-Steagall reinstatement and 2. against an over-regulating as a reaction to the Depression.

    I do believe that no regulation i.e. no oversight is bad. But, deregulation is good. There is no reason for the U.S. to go back to the days of a strictly regulated banking or airline market. However, one must understand that newly deregulated markets almost by definition invite euphoria and irrational exuberance. This needs oversight to prevent the Euphoria from getting out of hand. Remember deregulation and no oversight are not synonymous. There is a role for regulators as the Madoff affair has shown.

    In the case of the airlines, I think we should have liquidated a number of them long ago. They have been propped up artificially by government action. There is tremendous overcapacity there. So, I am definitely not arguing for the 1970s.

    In the case of the banks, what was needed was oversight and an enforcement of the rules already on the books, not new regulation like a re-institution of Glass Steagall. But, I fear that this is what we will get.

    I hope that puts this post in perspective.

  5. Wag the Dog says

    I guess one needs to clarify the distinction between oversight, self-regulation (euphemism for no oversight, no regulation), and “light-touch” regulation (Gordon Brown’s variant of weakened oversight). Regulation without oversight can be far more pernicious as there is the illusion of fail-safe where none exists.

  6. Econophile says

    Thank you for your clarification, but … I find your arguments in the original post to sound rather non-free-marketish. I am sure you have been reading some of Rogoff and Reinhart’s work on business cycles that point out business cycles are always caused by monetary expansion, which research fits nicely into Austrian theory.
    I believe they point out the UK as one example of that. I’m not suggesting that anyone adhere blindly to a theory but I guess I’m lost when you say you are a free market advocate. But then, reasonable minds can disagree.

  7. Edward Harrison says


    I think you hit the nail on the head.

    I do think that you have to lay down some sort of comprehensive set of guidelines within which financial institutions will operate. There has to be some road map otherwise no one will invest in them. So in that sense the regulators would have to make it pretty clear exactly how the institutions will be allowed to grow and what activities they will be allowed to participate in.

    A general framework is necessary that lays out fairly concretely when and how regulatory oversight will be used. I would consider this to be ‘regulation-light’ but oversight-medium versus the likely regulation-heavy and oversight-medium.

    But we knew this was coming a long time ago. And we also knew that more funds would be used to administer the type of oversight necessary.

    Econophile, my original arguments, parsed as they are here, are pretty much in line with my general thinking i.e. regulation-light plus oversight-medium is superior to regulation-light and no oversight or regulation-heavy and oversight-medium.

    The key is to let companies operate their businesses as they see fit within a regime that has well-understood controls and checks. This makes the chance of getting caught greater, and reduces the incentive to cheat the system as Tom Lindmark says. But, again one needs to fund regulators accordingly.

  8. Econophile says

    This is a reasonable conclusion within our existing framework. I do believe that the political process gets in the way of any regulation, and that general incompetence will always be a barrier to stopping financial innovation or thievery (Madoff). I wrote an article on my site on the possibility of a new risk czar back in August, somewhat tongue in cheek. http://dailycapitalist.com/2008/08/25/president-obama-appoints-nobel-laureate-mcfadden-to-head-new-financial-risk-commission/

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