– May 10, 2017

Folklore is powerful. Scarcely examined stories are repeated for generations and accepted as true, influencing people’s worldviews and often driving government policy. For example, everyone “knows” that the free market, and specifically the combination of commercial and investment banking, helped cause the Great Depression, that the heroic Glass-Steagall Act of 1933 (the banking reform of Franklin Roosevelt’s that separated the two kinds of banking) prevented a recurrence of a major depression for decades, and that the repeal of Glass-Steagall in 1999 during the Clinton administration prepared the ground for the Great Recession of 2008. Typical was Barack Obama, who, when he ran for president in 2008, the year the recession began, said, the repeal “encourag[ed] a winner-take-all, anything-goes environment that helped foster devastating dislocations in our economy.”

Thus it is commonly concluded that America needs an updated Glass-Steagall. Indeed, President Trump, who criticizes the Dodd-Frank banking regulation of the Obama administration, nevertheless says he is considering a “21st-century” Glass-Steagall Act. He has the backing of Treasury Secretary Steven Mnuchin and National Economic Council Director Gary Cohn.

But as someone once said (we really don’t know who), “It isn’t what we don’t know that gives us trouble. It’s what we know that ain’t so.”

What many people know that ain’t so is that Glass-Steagall fixed a problem that had caused the Great Depression, that its repeal led to the Great Recession, and that reinstatement would make our economy sound.

In reality, Glass-Steagall’s separation of commercial and investment banking was a solution in search of a problem, according to economic historians Jeffrey Rogers Hummel and Warren C. Gibson. They point out that while commercial and investment banking seem vastly different — the former matches depositors/savers with borrowers, the latter underwrites the issuance of stocks and bonds — the roles overlap:

Some of the skills and practices of investment bankers are quite similar to those of bank-lending officers. Lenders must investigate the creditworthiness of prospective borrowers. Investment bankers must perform the same sort of due diligence in deciding whether to underwrite a proposed security offering and if so, how to price it. Firms that combine commercial and investment banking under one roof thus tend to be more efficient, a situation that economists call “economies of scope.” If they successfully exploit economies of scope, combined firms provide lasting benefits to their corporate clients and indirectly to consumers, as well as higher profits to themselves — at least until competing firms bid away those profits.

Fine. But what of the dangerous conflicts of interest that were said to arise by combining commercial and investment banking? Hummel and Gibson reply:

It is certainly possible that a banker in a combined firm might steer customers into ill-suited investments or insurance products. This is a hazard we face whenever we deal with professionals, such as physicians who advise treatments and also provide them, or lawyers who advise lawsuits and offer to file them. Such hazards are manageable: We can always get a second opinion or consult a fee-based financial planner or simply rely on the professional’s incentive to maintain a reputation for ethical service.

But what about the history of abuse about which everyone “knows”? This is where the folklore kicks in. The separation of commercial and investment banking had long been favored by Sen. Carter Glass, a sponsor of the Federal Reserve Act of 1913, and he finally got his way thanks to a few anecdotes that allegedly document abuse by so-called universal banking. Hummel and Gibson note, “In his 1990 book, The Separation of Investment and Commercial Banking, Professor George Benston investigated numerous … charges against NCB [National City Bank] and showed that none had any substantial basis in fact. Similar charges were brought against the Chase Bank, its president Alfred Wiggins, and the affiliated Chase Securities Corporation. Benston also showed that these charges were mostly unsubstantiated.”

Hummel and Gibson demonstrate the “witch hunt” nature of the congressional hearings on Glass-Steagall. For example, the chief counsel for the Senate Committee on Banking and Currency alleged that NCB’s subsidiary, National City Company, bought a substantial amount of stock in the new Boeing Corp., but rather than sell the shares, the company (in the chief counsel’s words) “retained a large block for itself and allotted the remainder to [President Charles] Mitchell and a select list of officers, directors, key men, and special friends.” The company did this, according to an internal document, because “this industry is still somewhat unseasoned [and] we were not quite ready to make a general offering to our customers.”

If that sounds like something other than abuse, you are paying attention. Hummel and Gibson comment, “Not only does this not sound improper, but in fact it sounds like just the sort of prudent regard for customers’ best interests that was supposed be lacking in combined firms such as NCB/NCC.”

Thus universal banking could not have caused the 1929 stock market crash and the ensuing Great Depression. (The causes are to be found in the Federal Reserve System, the Smoot-Hawley tariff, a banking industry made exceedingly brittle by generations of government regulation, and the New Deal itself, which turned what could have been a brief recession into a long and deep depression.) Therefore the repeal of Glass-Steagall could not have set the stage for the Great Recession, which resulted from government guarantees to banks that made and securitized shaky mortgages.

Besides, Hummel and Gibson write, “By the 1990s Glass-Steagall was fast becoming a dead letter.” That is, before repeal, banks had already found ways around the restriction without creating problems. Some full-service banks succeeded, others did not, but consumers benefited from the convenience of an expanded array of services.

So the 1999 repeal was little more than a codification of reality, and therefore can’t reasonably be blamed for the Great Recession. “Incidentally,” Hummel and Gibson add, “no other developed country has ever seen fit to separate commercial banking from investment banking.”

The reasonable conclusion should be clear: sound banking does not require a 21st-century Glass-Steagall Act. Rather, it requires sound market-based money and an end to government guarantees to banks, such as the Glass-Steagall Act’s federal deposit insurance, which sadly was not part of the Clinton-era repeal.