Many things are happening in the new populist phase of American politics. Some are less expected than others. For instance, the GOP joining forces with the left of the Democrats in asking for the restoration of Glass-Steagall was not something many saw coming. The new Republican Party platform calls for restoring the law that separated commercial-banking and securities activities at Wall Street firms, a regulatory change advocated by both Elizabeth Warren and Bernie Sanders. The following offers some background on this law and how it is linked to the regulation of financial markets in the US.
Glass-Steagall is the offspring of crisis and a totemic legislation of the New Deal. Crisis can be (and many argue, indeed, it should be) a catalyst in developments in policy that can at times lead to rapid and wholesale reversals of policy directions. One such reversal was the expansion of regulation in the United States after the 1929 crash and the initiation of the New Deal by the Roosevelt administration. As a product of pressure from various sources, the New Deal was grounded in no single coherent or systemic theory. Perhaps the most prominent unifying theme was the popular conviction that an unregulated free market guided solely by the invisible hand of private interest could lead only to the dispossession associated with the depression. The Roosevelt administration responded to this popular perception (in sync with Keynes’ ideas) by offering the countervailing power of government, administered by disinterested expert regulators, in order to discipline the market and stabilise an economy that laissez-faire had all but destroyed. The result was a stunning expansion of administrative authority both within and independent of the executive branch. What is particularly interesting is that the state sought to set in place a regulatory framework that would prevent the re-emergence of circumstances that could lead to another bubble and subsequent catastrophic crash.
One of the most important legislative responses to the failures of the Depression (particularly in the banking sector) was the work of Senator Carter Glass, Representative Henry Steagall and other proponents of the Banking Act of 1933, known as the Glass Steagall Act. The Act’s backers were convinced that the banks had played a significant role in promoting unsustainable booms in the real estate and securities markets during the 1920s. As a solution to this problem it was suggested that commercial banks should restrict their operations to the acceptance of demand deposits and the extension of short-term, self-liquidating loans to finance the production and sale of goods by businesses. Banks therefore should be prevented from making unsound loans and investments that encouraged an overbuilt real estate market and an immense overexpansion of real estate values. The banks should also be discouraged from making investments in securities that undermined their solvency during stock market downturns and they should be restricted in making loans to finance the purchase of securities. Liberalisation that removes the above restrictions has since been shown to produce a banking system that is more vulnerable to systemic risk. Admittedly, deregulated financial markets generally promote faster growth rates by providing more extensive financing to consumers and businesses during economic expansions. However, by encouraging greater reliance on external funding, deregulation creates a higher risk that consumers and firms will become overextended and end up insolvent if external funding sources shut down during economic contractions. An example of this happening was the credit crunch of 2008. As Amato and Fantacci explain in their book The End of Finance, the reliance of the economy on ever-increasing availability of funding (known as liquidity) propels what is a market economy to its turbo-charged, crisis-prone financialised version, something the aforementioned authors equate with modern capitalism.
The financialisation that came to characterise US (and global) capitalism before the crash of 2008 was the product of protracted deregulation. While deregulation has been a dominant trend in the US since the mid- 1980s, it came properly into its stride in the latter part of the 1990s. By 1998 regulators and the courts in the United States had allowed banks to make substantial inroads into the securities and insurance sectors by exploiting loopholes in the Glass Steagall Act and the Bank Holding Company Act of 1956, both enacted with the memories of the Great Depression present in people’s minds and considered strong legal barriers to bank entry into the securities and insurance fields. The model of finance to emerge after the repeal of the Glass Steagall Act was based on securitisation and became known as the ‘originate and distribute’ model. A securitisation is a financial transaction in which assets are pooled together and securities representing interests in the pool are issued (see here for an explanation). Under the originate and distribute model, financial institutions would create assets (such as loans) then repackage these and sell them to investors. The resulting funds would be used to originate more assets which in turn would be re-repackaged and sold, recommencing the cycle. This model of banking recreated in a way the institutional framework that had led to the crash of 1929. By allowing the banks to lend not on the basis of deposits but on the strength of the money markets, the way was opened for the financial sector to depart from the fundamentals of the real economy, creating fictional wealth.
In confirming the return of universal banking powers to the financial holding companies, allowing the combination of commercial with investment banking, the Gramm-Leach-Bliley Financial Modernization Act repealed several Depression era safeguards in 1999. Unlike the system of finance established in the United States in the 1930s, the new model of finance allowed competition between commercial banks and investment banks for securities business. As a result, opportunities for profit increased dramatically, encouraging investment banks to engage in ever more risky proprietary trading – speculating with their own capital to increase returns. A key boost to the trade of derivative financial products via the process of securitisation we just described was given by another major step in deregulation in the form of the Commodity Futures Modernization Act of 2000. The new legal framework was not merely reflecting innovations in financial markets, but changes in the law spawned the so-called innovations. In other words, it was not changes to the markets that brought about the conditions that created the credit crisis but, crucially, changes in the law. The Commodity Futures Act suddenly and totally removed century-old legal constraints on speculative trading in over-the-counter (OTC) derivative financial products. It is useful to remember that derivatives were not always seen as a clever way to speculate but rather as a risk limitation technique. Derivatives were considered in US jurisprudence to be valid methods of dealing with risks of future events, and while hedging was legal, speculation in OTC derivatives was not and courts would not allow enforcement of financial bets whose sole purpose was speculation (as opposed to risk diversification). One way that the pre-2000 system dealt with speculative derivative trading was by moving it to clearing houses which assumed the risks associated with such transactions and kept the volume of trading low in order to minimise the exposures of the clearing houses themselves. This system operated fairly consistently on the basis of the common law (eventually codified by the Commodity Exchange Act of 1936), which retained the prohibition of speculative trading outside regulated exchanges. The Commodity Futures Act of 2000 represented the final blow to this system of controlled derivative trading. After the Act, speculative trading in derivatives was in effect legalised in the US with the result that a massive market in OTC products grew with-out anyone being able to assess the systemic risk effects of ever expanding volumes of trading.
The response, post credit crunch, at least in the US, has been to try and reverse the tide by restoring legal limits to derivatives trading outside clearing houses in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Will reinstating 1930s era regulation deal with the risks of further crises stemming from financial markets? It is correct that on its own this initiative cannot be a cure-all. On the other hand a more controlled, smaller financial sector has lessened capacity to destroy the real economy during one of its cyclical, self-generated disasters.