The loud thuds heard across America this week were not just the sounds of Merrill Lynch and Lehman Brothers collapsing. It was also the crash of two conservative ideas–deregulation of the American economy and the privatization of Social security. Wall Street’s collapse thus portends both a requiem on a bankrupt political economic philosophy and new path for America. As such, the United States of 2008 is poised almost exactly where it was in 1933.
As Franklin Roosevelt assumed the presidency in 1933 America’s financial and banking system had collapsed. Broke due to stock speculation, the crash of 1929, and then a run on deposits, many bankers and members of Congress saw two options, nationalize the financial institutions or fix them up. FDR chose the latter. Among the key provisions to rescuing the banking system was the 1933 Glass-Steagall Act. The Act contained many well-known provisions, including the creation of the Federal Deposit Insurance Corporation to insure depositors’ money.
But Glass-Steagall also created two classes of banks–commercial and investment. The former would be barred from engaging in stock speculation and instead would be limited to making money generally through home and other types of loans. Investment banks would be permitted to speculate on Wall Street. Glass-Steagall was considered a major banking reform; it erected a firewall to prevent the type of speculation that occurred in the 1920s from repeating itself, thereby protecting financial institutions and the public from the problems that destroyed them with the crash of 1929.
For 66 years Glass-Steagall worked. It brought stability to banking institutions by securing deposits, limiting speculation, and encouraging home ownership. Commercial banks did well, earning solid and consistent returns for years. Glass-Steagall, along with many other pieces of New Deal legislation, such as Social Security, brought government regulation to the economy, producing a stable correction to the failures of free market laissez faire capitalism.
But the Reagan era challenged regulatory capitalism. Describing government not as the solution but the problem, it ushered in an almost cult-like belief in the infinite wisdom of the market to solve all problems. If individuals, guided by self-interest were free to choose, the market could replace the government, solve problems anywhere from pollution to school quality, and also make us rich. Thus, the Reagan era began the push to deregulate the economy from government controls, and it also spurred calls for other changes, such as the privatization of Social Security.
When the stock markets exploded during the 1990s, many market worshipers came to see Glass-Steagall as a quaint holdover from the New Deal era. Thus in 1999, senator Phil Gramm–and up until recently presidential candidate John McCain’s financial advisor–pushed through the repeal of Glass-Steagall, permitting yet again a merger of commercial and investment banking institutions. Now banks, eager to raise money to invest on Wall Street, had little incentive to deny loans to individuals. These loans would help provide the capital to invest in securities.
Yet when the real estate market busted and the defaults started, these events began a chain of events that first brought down Freddy Mac, Fannie Mae, Bear Stearns, and now Merrill Lynch and Lehman Brothers. Had Glass-Steagall still been in place the firewalls it had would have prevented the type of speculation and damage that is now occurring. Moreover, had the free marketers gotten their way with the privatization of Social Security and allowing individuals to invest this money on Wall Street, the damage of the last few days would have been even worse.
The events of the last few weeks demonstrate the limits of deregulation and an infinite faith in markets. They should be stakes in the heart of the Reagan era philosophy that government is bad. The events of the last few days have also brought us back to the 1930s, with a financial system similarly in shambles. What should be done?
Unfortunately the Bush Administration bailouts and rescues are the wrong courses of actions. They reward banks for making bad choices and leave untouched three basic problems, falling home equity, foreclosures, and the speculation brought on by the merger of commercial and financial banks. Bailouts are but band-aids and do little to address these basic problems. Where should reform go?
First, reinstate the firewalls of Glass-Steagall to restore stability to the financial institutions and eliminate the type of speculation that brought on the current mess. Second, institute a moratorium on home foreclosures for a least one if not two years. This moratorium keeps people in their homes and prevents a further glut of houses from hitting the market, thereby preventing a further skid in home prices.
But finally, instead of taking the path that FDR did in 1933 in refusing to nationalize the banks, take them over as the Bush Administration is doing, but maintain them as government institutions run not for profit but for the public interest. The surest way to prevent future irrational speculation is to place the banks under public control. Use the profits they generate to ensure Social Security’s solvency, keep people in their homes, provide health care for the uninsured, build and repair the roads and bridges we have neglected, and make the investments in the economy we need but have failed to provide.