A Previously Unrealized Failure Mode of delong
Twitterstorm delong: October 19, 2011

No, the Repeal of Glass-Steagall Was Not a Major Cause of Our Lesser Depression--But That Is the Wrong Question to Ask

Mark Thoma:

What Can We Learn From the Emerging Details of the Volcker Rule Proposal? - CBS MoneyWatch.com: What is the Volcker Rule?: The Volcker rule prevents firms from engaging in… proprietary trading… when a financial firm uses… its own money, to try and profit by trading…. The problem is that if these trades get the firm into trouble, and if the firm is… backed by an implicit or explicit government guarantee, then the firm is likely to take on too much risk… since losses are likely to be covered [by the government] to a significant extent[. Such firms] are more likely to get into trouble that requires a government bailout and taxpayer losses. The Volcker rule attempts to prevent firms from engaging in this type of behavior….

[W]hether the elimination of the Glass-Steagall act caused the present crisis is the wrong question to ask. To determine the value of reinstating a similar rule, the question is whether the elimination of the Glass-Steagall act made the system more vulnerable to crashes. When the question is phrased in this way, it’s clear that it has made the system more vulnerable…

A decade ago we (1) did not worry about the vulnerability because we believed the Federal Reserve had the power and the will to build a firewall between finance and the real economy to keep a financial collapse from leading to high unemployment, and (2) thought that the existing investment banking oligarchy--Morgan Stanley, Goldman Sachs, and company--could use some healthy competition from players with deep pockets like Citigroup, Chase, and Bank of America. Now we have rethought all these issues, and come to different conclusions.