Clinton on Glass-Steagall: Right or wrong?

Commentary

In Saturday's Democratic presidential debate, Hillary Clinton said she opposed reimplementing the Glass-Steagall Act, which had been repealed in 1999. When the financial crisis struck in 2008, many people blamed the disaster on the removal of the restrictions Glass-Steagall had imposed on banks. However, the evidence doesn't support this claim, which makes Clinton correct. But that doesn't mean ending Glass-Steagall was a good idea or that repeal could never cause the kinds of problems that lead to a financial crisis, which makes her wrong.

Indeed, the absence of Glass-Steagall does leave the country vulnerable to another financial meltdown, and that needs to be fixed.

Enacted as part of the Banking Act in 1933 in response to the Great Depression, Glass-Steagall imposed a separation between investment banking and commercial banking. This prevented federally backed deposits in commercial banks -- the type the public uses -- from being used to finance the much riskier activities of investment banks.

The problem is that with the government guaranteeing deposits in commercial banks, investors have no incentive to monitor the ways those banks use their deposits. That gives banks the freedom to undertake highly risky ventures without having to worry that depositors will move their money elsewhere. If the ventures are successful, the payoff is large. If they fail, the government covers the losses. Heads the bank wins, tails the taxpayer loses.

One solution to this problem is to separate investment banking from commercial banking, and then regulate the amount of risk that commercial banks are allowed to take with government-guaranteed deposits. That was the essence of the Glass-Steagall Act.

However, it was repealed in 1999 during the Bill Clinton presidency, with very little opposition in Congress. The main arguments were that banks in other countries weren't subject to such restrictions, which put U.S. banks at a competitive disadvantage, and that the market in conjunction with regulatory restrictions would be sufficient to limit the amount of risk that commercial banks could take.

For example, even after repeal, banks were supposed to keep commercial and investment funds separate, but it's not easy for regulators to enforce this restriction.

Did repeal cause the crisis? On this point, Hillary Clinton is correct: The evidence points elsewhere. For the most part, the main problems during that crisis didn't involve banks that offered both commercial and investment services. Instead, the problems were primarily at traditional investment banks. Had Glass-Steagall remained in place, the financial crisis would almost surely have happened anyway.

But that doesn't mean the repeal was a good idea and that it should continue. On this point, Clinton is wrong. Just because it didn't cause this crisis doesn't mean it could never cause a crisis. If a structural problem with your house caused part of it to collapse, and in the process of diagnosing that problem and fixing it you discover another big potential structural issue, both problems should be fixed. Why rebuild the house knowing a similar collapse could reoccur?

So, even though the repeal of Glass-Steagall didn't cause the most recent financial crisis, why leave the risk in place? Those opposed to reimplementing the Glass-Steagall sort of restrictions argue it would hamper bank activities and leave them at a disadvantage. But that's largely because the banks aren't the ones who will pay the bill if they're wrong. In fact, they would likely get bailed out.

The economic costs associated with a financial meltdown are extraordinarily high, and the costs fall mostly on people who had nothing to do with causing the crisis. Those who become unemployed, lose their houses and so on pay the largest costs, which continue for many years after the crisis itself has ended.

The costs associated with Glass-Steagall restrictions on bank activities are small relative to the benefits of avoiding another financial crisis, and the objections of the financial industry shouldn't stand in the way of a more stable financial system.