Fresh Conservative Ideas: Break Up The Banks

Luigi Zingales, drawing praise from the right’s intelligentsia as the writer whose book “hits closest to the mark on the question of where the American center-right ought to go”, believes that we should reenact Glass Steagall:

I have to admit that I was not a big fan of the forced separation between investment banking and commercial banking along the lines of the Glass-Steagall Act in the US. I do not like restrictions to contractual freedom, unless I see a compelling argument that the free market gets it wrong. Nor did I buy the argument that the removal of Glass-Steagall contributed to the 2008 financial crisis. …

Over the last couple of years, however, I have revised my views and I have become convinced of the case for a mandatory separation.

There are certainly better ways to deal with excessive risk-taking behavior by banks, but we must not allow the perfect to become the enemy of the good. In the absence of these better mechanisms, it makes perfect economic sense to restrict commercial banks’ investments in very risky activities, because their deposits are insured. Short of removing that insurance – and I doubt commercial banks are ready for that – restricting the set of activities they undertake is the simplest way to cope with the burden that banks can impose on taxpayers. …

I realised it was not simply a coincidence that we witnessed a prospering of securities markets and the blossoming of new ones (options and futures markets) while Glass-Steagall was in place, but since its repeal have seen a demise of public equity markets and an explosion of opaque over-the-counter ones.To function properly markets need a large number of independent traders. The separation between commercial and investment banking deprived investment banks of access to cheap funds (in the form of deposits), forcing them to limit their size and the size of their bets. These limitations increased the number of market participants, making markets more liquid. With the repeal of Glass-Steagall, investment banks exploded in size and so did their market power. As a result, the new financial instruments (such as credit default swaps) developed in an opaque over-the-counter market populated by a few powerful dealers, rather than in a well regulated and transparent public market.

The separation between investment and commercial banking also helps make the financial system more resilient. After the 1987 stock market crash, the economy was unaffected because commercial banks were untouched by plummeting equity prices. During the 1990-91 banking crisis, securities markets helped alleviate the credit crunch because they were unaffected by the banking crisis. By contrast, in 2008 the banking crisis and the stock market crisis infected each other, pulling down the entire economy. …

Presumably, then, center-right folks will not be voting for Republicans.

(Via). “Fresh conservative ideas” was the phrase that Lamar Alexander used to say over and over again when he was running for president. Earlier post on real-world events disabusing folks of libertarian fantasies here. Zingales is a professor at the University of Chicago’s Booth School of Business, which a few months ago in a survey of economists found:

The first question asked whether the stimulus increased employment by the end of 2010. Eighty percent of the polled economists agreed. Four percent disagreed. Two percent were uncertain. The second question asked whether, over the long run, the benefits would outweigh the long-term costs (like paying down the extra debt). Forty-six percent agreed. Twelve percent disagreed. Twenty-seven percent were uncertain. …

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