The Puzzling Return of Glass-Steagall

I am puzzled by the renewed demand for the return of Glass-Steagall. I am puzzled not because Glass-Steagall might be bad policy but because it is so clearly a policy that doesn’t deal with the problems that created the financial crisis. If one had to sum the crisis up in one sentence it would be hard to do better than “a run on the shadow banking system.” The shadow banking system is that collection of mostly non-bank financial intermediaries who base their credit creation not on deposits but on repo, money market funds, SIVs, asset backed securitizations and other financial structures. The big new fact that I learned from the financial crisis and that I thought someone like Elizabeth Warren would surely also have learned is that the shadow banking system is larger than the regular banking system.

Separate commercial and investment banking? Please. The problem was that investment banking, in the form of shadow banking, become so separated from commercial banking that the Fed no longer had any idea where a majority of credit was being generated. Credit creation separated from banking as understood by the Fed, and moved into the shadows, hence, the term shadow banking.

Compare Glass-Steagall with the Gorton-Metrick proposal to reform banking. GM would in essence extend deposit insurance to the shadow bank system, i.e. instead of separating commercial and investment banking, Gorton and Metrick would erase the distinction entirely by making all credit creators regulated commercial banks. (I exaggerate, but only slightly). If you don’t like that idea then consider Larry Kotlikoff’s limited purpose banking. Kotlikoff, in essence, goes the full Rothbard–separate lending from money warehousing (i.e. transaction-cost reducing money services) (Tyler offers some criticisms here).

Now whether you think the Gorton-Metrick or Kotlikoff proposals are good ideas, and I am not arguing for either, these ideas at least addresses the important issues. In contrast, Glass-Steagall would merely shuffle around organizational boxes in the less important regulated banking sector. Indeed, why would anyone think that 1930s policy is the solution to a 21st century problem?

Addendum: Here are previous MR posts on Glass-Steagall. FYI, my paper on the public choice aspects of Glass-Steagall showed that the public reasons for the original Glass-Steagall were not the private reasons. Is something like this going on today?


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