Glass-Steagall making a comeback? A historical look.

Posted by Arkady K. On 2/03/2010

This topic may sound mundane, but understanding the history behind this controversial act is important to absorb as talks about it's reinstatement heat up.  Glass-Steagall was repealed in 1999 by the Gramm-Lichey-Bliley act and has been blamed by many as the primary cause of the 2008 Housing Crisis.  Recently John McCain and ex-Fed chairman Paul Volcker proposed the return of Glass-Steagall along with many Democrats and prominent bloggers including Karl Denninger of Market Ticker fame.  However without examining the history of Glass-Steagall and the cause of it's existence can lead to needless legislation and shift the conversation away from the true root cause of our financial system.

To begin with, we need to zoom back in time to 1933 during the midst of the Great Depression.  We know tensions were running high, people were angry and rightfully demanded retribution.   Starting with Herbert Hoover and continuing with FDR, banks and Wall St. were used as whipping boys for the country's problems. This tradition has continued to this day and is largely responsible for the grave misunderstanding of why the Great Depression began in the first place.   Multiple banking reforms were passed in the next several years including Glass-Steagall which among other things performed the following:  Separation of commercial and investment banking and the implementation of the FDIC, our country's most beloved insurance program.   This very separation has been credited with preventing a crisis and it's demise in 1999 is used as proof of the 2008 collapse.  One can argue that this is a case of causation versus correlation, but I digress.

We now turn to Alexander Tabarrok's piece on The Separation of Commercial and Investment Banking: The Morgans vs. The Rockefellers which draws heavily form the biographer Ron Chernow and his important work the House of Morgan.  While much of the paper concentrates on the inner workings of the two most powerful families in America at the turn of the century, one fact remains clear, virtually everything was touched by either the Morgans or the Rockefellers.  In fact the Federal Reserve was conceived, drafted and put in place by Morgan/Rockefeller interests with the help of a powerful senator, Nelson Aldrich, whose political success was funded largely by Rockefellers. While the Federal Reserve is hailed by many as an institution that stopped banking panics, stabilized the markets and helped unemployment the truth behind the Federal Reserve's formation was purely for the empowerment of America's most powerful families and it's failure has been neglected, under-reported and undocumented. These two families competed fiercely over market share and used the Congress as a heavy bludgeoning tool, a tool that many large corporations have since utilized to stifle competition.  In 1930s the Rockefellers launched a massive offensive against Morgan interests and the powerful New York Federal Reserve which was governed by Morgan man Benjamin Strong during the 1920s and responsible for one of the greatest monetary inflations in America's history.

These attacks took shape in the Pecora-Glass Subcommittee hearings lead by Rockefeller sympathizer Ferdinand Pecora at the insistence of FDR himself.  Pecora already harbored anti-banking views stemming from Hoover's administration and Hoover's misguided view that credit expansion caused the heated stock market, as if cheap money could be somehow controlled (it cannot).  These hearings proved devastating for the House of Morgan as the public learned about Morgan's preferred stock sharing lists and the shocking revelation of not paying any income taxes in 1931.  Even though this income tax loophole was perfectly legal on the account of massive losses the American public was furious.  Furthermore the Pecora hearings concluded that banks with combined commercial and investment interests were extremely risky and hazardous to the public.  Unfortunately all follow-up research on these hearings failed to produce any evidence to support this assertion!  In fact, as Tabarrok writes:
White(1986) has examined the failure rate in 1930-1933 of national banks without security affiliates and national banks with security affiliates.  He finds that banks without security affiliates were four times as likely to fail as were those with affiliates.
Interestingly enough, unified banks (those with investment arms) from 1927 to 1930 greatly increased their issuance of bonds, solid proof their businesses were strong and more trusted than just purely commercial or investment banks alone.   Another study quoted in Tabarrok's research suggested that unified banks simply issued higher quality securities than exclusive Investment banks.  So if there was no empirical reason for separating the commercial and investment banks, then what is the explanation behind Glass-Steagall?

For this we examine Winthrop Aldrich, the son of Nelson Aldrich who by 1933 was a powerful banker and president of Chase National (a Morgan/Rockefeller merger).  Under Aldrich his bank suspiciously split it's commercial and investment banking arms and he threw his support behind Glass-Steagall.  Aldrich then proposed that all private banks be heavily regulated and forced to separate their commercial/investment interests while banning interlocking directorates (especially damaging to Morgans, as Morgan men dominated boards of multiple banks).   In hindsight it is now clear these separations would gravely hurt Morgan banking interests despite causing some frustration to Rockefeller interests, the damage done to Morgans far outweighed the damage done to Rockefellers.  At the time New York Times published stories with headlines describing Aldrich and Rockfeller interests striking at JP Morgan and Company.  In fact, Carter Glass who was a friend of Morgans had no intention of separating the private banks with the original bill only including provisions pertaining to national banks.  His private letters later indicated that he went along with Aldrich's lobbying efforts due to "being pressured by the administration".  As Rothbard writes in his epic A History of Money and Banking in the United States:
"It is a tragic irony that Carter Glass and his theoretician H. Parker Willis were lured into this alliance with the Rockefellers and the New Dealers to clobber the Morgans by coercively dividing commercial and investment banking....Hence the luring of Glass and Willis into uncongenial schemes of socializing and carterlizing Wall Street and helping the Rockefellers destroy the Morgans."
This tragedy stems not only from an example of powerful money interests controlling our politicians, a problem that continues to this day, but because Carter Glass/Willis despite being hard money conservative Democrats misjudged at the time the machinations of the banks.  They believed that banks were buying up corporate securities or lending money to the stock market, while ignoring the more simpler and devastating problem of bank credit expansion.   Bank credit expansion fueled by cheap money from the central bank  propelled a massive economic expansion during the 1920s culminating in a gigantic stock bubble and real estate speculations in parts of the country.   This is one of the primary causes of the stock market crash and immediate contraction that began in 1929.   So not only were the causes of the immediate contraction misunderstood by observers during that time, but as can be seen, much of the legislation passed in the early years centered around private interests or to appeal to an angry public whose anger was constantly stoked by Hoover and FDR himself.

So here we are in 2010 and not much has changed.  Once again the public is provoked into focusing it's anger on failed free market principles and corporations while public servants act as modern day Robin Hoods waging war on the familiar scapegoats.  Yet much of New Deal's legacy centers around destroying the free market, not only by coercive separation of banking interests, but by one of the least understood and most vile aspects of Glass-Steagall, the FDIC.  Federal Deposit Insurance has essentially transformed the already ailing banking industry, already being centrally managed and controlled by a Federal Reserve, into an industry where failure was no longer an option.   One of the key components of a healthy and vibrant free market is the exchange and communication of information between customers and producers, where customers voice their discontent by taking their business elsewhere.  Yet the FDIC strips that piece of information away and transforms banks from a legitimate business into puppets of government's credit expansion mechanism.  There is no reason why a bank should be prevented from failing and yet after the Great Depression people grew accustomed to be shielded from failure, a transformation that has numbed and dumbed down people's understanding of banking and finance.  Failing banks were once the only way to determine if credit expansion went too far and a signal to the public to act preemptively and punish bad banks, now a thing of the past.  Did the repeal of Glass-Steagall exacerbate the problem and expedited failure?  Of course it did, but in lieu of a healthy banking system we should be grateful that we can at least be exposed to our broken financial system and we should under no circumstance fight to patch it back up.

Once again we are ignoring grave changes to our financial system over the past several decades while continuing to misunderstand the implications of fractional reserve credit lending backstopped eternally by the Federal Reserve and the US Government able to create money out of thin air.   When people clamor for the return of a piece of legislation that was designed by powerful interests for their own agenda, they shift the discussion in the wrong direction.  We need to be discussing our broken monetary system and our perplexing reliance on a Federal Reserve to pump liquidity into an economy functioning solely based on the continued expansion of debt to uphold the growingly fragile Ponzi financing.   Virtually all the New Deal programs were band-aids on top of problems that were not properly understood and yet we continue to promote the same kind of approach time and time again.  As discussed earlier in the example of Shays' Rebellion, our politicians and lobbyists have a chronic misdiagnosing problem that manifests itself in prohibitive pieces of legislation that either cause new sets of problems or fail to address the old ones.  People like McCain and Volcker would be true public servants if they educated the public in actual causes of some of our biggest problems, instead of pandering to an ailing public while invoking archaic and useless band-aids to solve our nation's critical issues.
"It is no crime to be ignorant of economics, which is, after all, a specialized discipline and one that most people consider to be a ‘dismal science.’ But it is totally irresponsible to have a loud and vociferous opinion on economic subjects while remaining in this state of ignorance.” - M. Rothbard