In the midst of doing a lot of things wrong, the Obama administration appears to be about ready to take some steps in regulating the big banks on Wall Street that, if the details are carefully drawn, will make our financial system more secure while reining in institutions that were determined to be “too big to fail.”
On Thursday, Mr. Obama proposed a plan that would prevent banks that receive a federal backstop from investing their own money in financial markets—what is known as proprietary trading. He also pushed for new limits on the size and concentration of financial institutions. Both moves echo the Glass-Steagall Act, the Depression-era banking curbs that was repealed in 1999.
The proposal marked the return of Mr. Volcker to center stage in the Obama White House. The 82-year-old chairman of the president’s Economic Recovery Advisory Board consulted closely with Democrats in the House and Senate as they drafted their proposals to address “too big to fail” entities, referring to financial behemoths whose collapse might bring down the economy. Mr. Volcker spoke frequently with Mr. Obama as well.
But he faced a philosophical divide with others on the economic team.
The Geithner-Summers axis in the White House has been opposing the virtual re-imposition of Glass-Steagall for months. This decision by the president makes me think that one or both of them is on their way out - and soon. Geithner is the logical choice to take a long walk off a short pier, having angered just about everybody but executives who benefited from his bank bonus policies.
My guess is the ax will fall right before the State of the Union speech, perhaps as soon as this weekend. Obama will use SOTU to probably ask for a fresh start from the American people and he’s not going to be able to do that without some heads rolling - especially among those who have been responsible for implementing his economic policies.
The experiment of having a financial system free of Glass Steagall constraints has failed. Jim Manzi at American Scene, in an excellent summary of the new regs, explains why:
Finance professionals, like members of all occupational categories, attempt to build barriers that maintain their own income. One of the techniques used is to shroud what are often pretty basic ideas in pseudo-technical jargon. The reason that it is dysfunctional to have an insured banking system that is free to engage in speculative investing is simple and fundamental. We (i.e., the government, which is to say, ultimately, the taxpayers) provide a guarantee to depositors that when they put their savings in a regulated bank, then the money will be there even if the bank fails, because we believe that the chaos and uncertainty of a banking system operating without this guarantee is too unstable to maintain political viability. But if you let the operators of these banks take the deposits and, in effect, put them on a long-shot bet at the horse track, and then pay themselves a billion dollars in bonuses if the horse comes in, but turn to taxpayers to pay off depositors if the horse doesn’t, guess what is going to happen? Exactly what we saw in 2008 happens.
If you want to have a safe, secure banking system for small depositors, but don’t want to make risky investing illegal (which would be very damaging to the economy), the obvious solution is to not allow any one company to both take guaranteed deposits and also make speculative investments. This was the solution developed and implemented in the New Deal. We need a modernized version of this basic construct, and as far as I can see, this is what President Obama has proposed.
Glass-Steagall put up a wall between commercial banks and those banking institutions that make their living on Main Street. What was seen as an antiquated, outdated notion in 1999 when it was repealed, makes a lot more sense in retrospect. The deregulators forgot one gigantic truth about human nature; we are a fallen species, and if an opportunity presents itself to aggrandize one’s own wealth and power at the expense of another, few will resist such temptation.
Manzi’s point about risk is also well taken. We cannot overregulate to the point that risk is discouraged - especially in the competitive global business environment we find ourselves today. Intelligent risk taking is the essence of entrepreneurship and the government will have to walk a fine line between mandating responsible behavior by big investors while still allowing the magic of the market to bring new products and new ideas to the fore.
While some of the administration’s rhetoric on this issue has bordered on anti-business, the political ramifications of slapping Wall Street with new regs that will force them to act more responsibly to the economy as a whole are profound. Manzi again:
The political aspects of such reform are compelling. People are disgusted at recent bank bonuses. I’m a right-of-center libertarian businessman, and I’m disgusted by them. Make no mistake, many banking executives right now are benefiting from taxpayer subsidies. Even if they pay back the TARP money, the government has demonstrated that it will intervene to protect large banks. This can’t be paid back. And this implicit, but very real, guarantee represents an enormous transfer of economic value from taxpayers to any bank executives and investors who are willing to take advantage of it. Unsurprisingly, pretty much all of them are.
The “populist” observation that the fact of a bunch of well-connected guys each pulling down $10 million per year while suckling on the government teat constitutes almost certain evidence of self-dealing is accurate, and all the fancy finance talk in the world can’t get around it. President Obama has a clear political incentive to pursue this proposal. I assume Republicans will see that they have a clear political incentive to go along, rather than standing up for such a situation. Hopefully, this will create the political dynamic that will allow real, positive reform.
If the result of these regs is that we never hear the words “too big to fail” again, that will be fine by me. I am a little more convinced a year later that the intervention by government at the time was at least partly necessary, although I ask would it have been possible for the government to have tried a little harder to effect mergers and controlled bankruptcies rather than shelling out such huge amounts of taxpayer dollars. We’ll never know, which is why creating a regulatory regime to make sure that we never - ever - put the taxpayer in that position again is of paramount importance.