Charles W. Calomiris, who is Professor of Financial Institutions at Columbia Business School and a visiting scholar at the American Enterprise Institute, has recently published a paper on the lessons that can be drawn from the history of financial regulation.
“The Political Lessons of Depression-Era Banking Reform” looks more specifically at the regulatory response the last time the U.S. experienced a financial crisis of similar significance to the recent one–during the Great Depression of the 1930s:
“The ill-conceived banking legislation of the 1930s took very little time to pass, but a great deal of time to disappear. The overarching lesson is that the aftermath of crises are moments of high risk in public policy.”
The 1933 Glass-Steagall Act–named after its two main sponsors, Senator Carter Glass and Rep. Henry Steagall–was, in the words of Calomiris, “quick, comprehensive, and unusually responsive to popular opinion.” It was also based on a wrongful diagnosis of the causes of the crisis, something which is borne out by financial history.
The main components of Glass-Steagall was a cap on interest rates for bank deposits (Regulation Q), the separation of investment banking from commercial banking, and the creation of federal deposit insurance (FDIC). Ironically, these regulations were, according to Calomiris, put in place to “preserve and enhance two of the most disastrous policies that contributed to the severity and depth of the Great Depression – unit banking and the real bills doctrine.”
The high frequency of banking crises and banking failures in the period from the Civil War up to the mid-30s was something peculiar to the United States, resulting from its unique banking system, which in turn was a result of its unique banking regulation. In most states there were unit banking laws prohibiting banks from operating more than one branch. This led to a fragile banking system, one that was highly crisis-prone. Canada, which did not have these kind of restrictions, developed a nationally integrated financial system without banking crises.
The workings of the American banking system led to seasonal liquidity problems which from time to time evolved into full-scale liquidity crises and banking panics. In order to solve this problem, rather than abolish the geographical restrictions on banks, Congress established the Federal Reserve System in 1913. The Fed was quite successful in smoothing out the seasonal fluctuations in interest rates and demand for liquidity, but was not able to prevent the worst economic crisis in U.S. history–the Great Depression. (Economists and financial historians more or less agree that the Fed’s monetary policies in the early 1930s, as well as in 1936-38, exacerbated the crisis. However, there is disagreement among Keynesians, monetarists and Austrians on the causes of the initial stock market crash and economic downturn.)
The two main reasons for the catastrophic contraction in the money supply during 1930-33 were both political. One was the continued existence of the unit banking system, due to regulation. This laid the groundwork for a wave of bank failures around the country, something which in turn amplified the credit contraction. The other main reason was the Fed’s adherence to an antiquated monetary theory called the “real bills doctrine.”
As Calomiris explains:
“According to the real bills doctrine, the Fed should accommodate cyclical demand for credit related to trade, but not variation in credit demand associated with securities lending, real estate lending, or industrial or consumer lending. The central bank, therefore, was emphatically not in the business of targeting the growth of aggregate credit or money or economic activity or financial system health, but rather saw itself as ensuring that reasonable needs of trade finance were being met.”
Since the real bills doctrine “argued against stabilizing securities markets, banks, or the economy,” the Fed saw no need to alleviate the struggling financial sector by expanding the monetary base. As commented upon in a recent post, this is the opposite of the policy prescription that can be gathered from the monetary writings of Austrian economist Friedrich Hayek during the 1930s.
Hayek advocated stabilizing nominal spending by expanding the monetary base during such a contraction. Keynesians and monetarists likewise would advocate expansionary measures, though traditionally Keynesians emphasized fiscal policy (something Austrians are opposed to) as they thought monetary policy would be impotent. New Keynesians don’t share this view with their Old Keynesian predecessors.
More importantly, Austrians warn against credit expansion during a boom phase, arguing that this expansion is what leads to the credit contraction during the bust phase. Thus, the need for expansionary monetary measures in response to a crisis can be avoided all together if the authorities avoid creating a credit boom to begin with.
The focus of Calomiris’ paper, though, is not monetary policy but financial regulation. As he points out, the legislative response during the 1930s, most importantly the Glass-Steagall Act of 1933, actually sought to preserve the system of unit banks (through deposit insurance and Regulation Q limits on bank interest rate payments). These regulations fed into the U.S. banking crisis of the 1980s–the S&L crisis.
The third main component of Glass-Steagall was the separation of investment and commercial banking. Financial historian Eugene White (cited in Calomiris’ paper) has shown that this was a “red herring” in explaining the causes of the 1930s crisis. White has later called the abolition of this restriction in 1999 as another “red herring” in explaining the causes of the current crisis.
In fact, the new regulations which were enacted in response to the financial crisis of the 1930s did not address the real problems of the U.S. financial sector or the true causes of the crisis, but were put in place to further the agenda of the sponsors of the act. It also responded to the public outcry and resentment towards Wall Street. The act was passed hastily and without any real evidence of the claims the regulatory response was based on.
The parallels to the current situation are striking. The Obama administration and Congress Democrats are trying to harness the popular anger towards Wall Street in order to quickly pass comprehensive financial regulation. This takes place even before the Financial Crisis Inquiry Commission (FCIC) has finished its investigations. The move also seem to be an attempt at restoring popularity and voter confidence for the Democrats after the passing of the unpopular health reform bill earlier this year. However, the Dodd bill only vaguely seem to strike at the real underlying problems of the U.S. financial sector, as commented upon by Calomiris in a recent article. He also comments upon the bill in the conclusion to his paper:
“The Dodd bill has many flaws. It appears to reduce the chance of future bailouts of large banks through the creation of a new resolution authority. Such an authority may make sense […], but the details of the proposed authority as currently proposed (with little credible barriers to unwarranted bailouts and with the prefunding of bailouts through a financial bailout tax) would institutionalize bailout authority, making bailouts more likely. Just as the Federal Reserve Act of 1913 and the Banking Acts of 1933 and 1935 did nothing to address the fundamental problem of unit banking, the Dodd bill does nothing to address one of the primary causes of the crisis – politically motivated government subsidization of mortgage risk in the financial system […]”
Furthermore, to quote Stephen Roach, Chief Economist at Morgan Stanley, the proposals for financial sector reform “ignores the 800‐pound gorilla that is also in the same room–misdirected monetary policies.” Neither the Obama administration, Chairman of the Senate Committee on Banking Chris Dodd, Chairman of the House Financial Services Committee Barney Frank, nor Fed Chairman Ben Bernanke seem to think the recent financial crisis suggests there is any need for monetary reform.
Obama, furthermore, places great hope in establishing a central Consumer Financial Protection Agency, to regulate mortgage lenders, in addition to more stringent rules governing Wall Street banks. However, this is based in an unsubstantiated belief that predatory lending was the main cause of the subprime boom and subsequent bust, as opposed to unsustainable housing policies and historically low interest rates.
The speed at which the reform is sought to be enacted unfortunately jeopardize the ability for the legislators to identify the true, underlying problems of the financial sector and could undermine the possibility to come up with the right legislative response. Thus the proposed reform could end up as just another failed attempt at “fixing” the problems of the U.S. financial services industry–a sector that has been ridden with bad legislation during most of U.S. history.
The main lessons that can be drawn from the experiences of the banking sector is that the U.S. has a long history of bad financial regulation, creating unintended consequences that from time to time feed into full-blown crises. Second, a full-scale financial crisis creates circumstances in which ill-conceived legislation potentially arises, due to politicians who want to respond to public anger and who act before a more thorough investigation into the real, underlying problems have been conducted. This will likely create new, unforeseen problems that will materialize sometime in the future.