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Sunday, March 8, 2009

The Past is Present Again: Perhaps We’ll Learn This Time

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The Past is Present Again: Perhaps We’ll Learn This Time

John S. Cline


The current financial crisis could have been avoided or at least mitigated had political and financial elites avoided deregulating the financial industry, gutting oversight protections, retained transparency, and overhauled, rather than repealed, the Glass-Steagall Act. Following a history of United States commercial regulation, I will specifically examine financial regulation, comparing the effects before and after the repeal of the Glass-Steagall Act and discuss how its supposed "replacement", the Gramm-Leach-Bliley Act, created the current atmosphere for economic crisis. I will conclude with recommendations for 21st Century upgrades to all of our regulatory infrastructure.


The regulation of commerce has had a long and storied history, ranging from the Code of Hammurabi to Sarbanes-Oxley. From the rigid, regulate-everything Communist dogma to the Dickensian "are there no workhouses?" anything-goes free-for-all of the early Industrialization era, business regulation has played a greater or lesser role in political systems throughout history. Since the American Revolution, business regulation in the United States has taken many forms, has undergone sometimes radical changes as various progressive movements have exerted their power, and has especially been moving from a strictly local and state issue to a more national purview over the last century.

In this paper, we will examine how business regulation came about in the United States, conduct a historical overview of the rise of financial industry regulation, examine in detail two of the most important regulatory acts, the Glass-Steagall Act and the Gramm-Leach-Bliley Act, and demonstrate that the combination of the repeal of Glass-Steagall with poor oversight, over-speculation, poor transparency, and lax compliance created the conditions for the current financial crisis.

Death, Taxes and Regulation

Like death and taxes, it is impossible to avoid regulation in just about every aspect of daily life. There are two basic types of business regulation: economic and social (Litan). The first deals with price controls and entry limits, such as what maximum price can be charged for a product or service, or who can enter a field (board certification for doctors and lawyers, for instance). The second type of regulation has mostly to do with externalities (outside influences the company or industry may have, either acting upon it or how its actions will impact society). These range from employee safety standards to product quality controls, financial disclosure requirements to corporate governance, and unionization rules to environmental restrictions, as well as regulations covering a whole host of other arenas where the business may impact or be impacted by externalities. The (ideal) goal for government-imposed regulation is two-fold: it enforces competitiveness in the marketplace, which fosters innovation and retards complacency, while at the same time, it seeks to prevent abuses and overreaching by the business community to protect workers, consumers, and society as a whole (Feulner; Litan).

Business leaders’ reactions to government-imposed regulation range from one extreme to the other: unmitigated horror and unconcealed hatred for any attempt at governmental "interference" to tepid or even whole-hearted embracement of regulation. Even though most grudgingly agree that it is required in many cases to ensure a vibrant, competitive, and generally honest business environment, most simultaneously feel that government tends to err on the side of over-regulation, resulting in unnecessary increased costs and potential legal liabilities for their businesses (Litan).

As we will see, there is truth found on both sides of the argument for more or less regulation; too much regulation can stifle industry and discourage innovation, growth and market penetration, while too little regulation or oversight can result in abuses of consumer protections and even bring down entire economies (Feulner). The events of the last few months have increasingly focused international attention on the role of regulation in the marketplace, specifically on the affects of deregulation and lack of oversight.

Gaining the Power to Regulate: The New United States

In the economic and political shambles created by the American Revolution, the national government had little if any say in regulating commerce. Left by the Articles of Confederation without the power to tax, regulate interstate commerce, or enforce contractual obligations between individuals or states, Congress was basically side-lined to negotiating very limited diplomatic (typically non-commercial) treaties, managing Indian trade (outside the states’ jurisdictions), and regulating weights, measures and the value of coinage (Bernstein, Articles of Confederation, Articles IV, VI, VIII, IX, XII). In this environment, the national government was held hostage by the individual states; it was a "gentlemen’s agreement", wherein each state controlled its own affairs and Congress had no real power to enforce compliance with the Articles. Needless to say, in the decade it was in effect, the Articles resulted mostly in confusion and acrimony rather than cooperation and harmony. States erected ever more restrictive tariffs on other states’ goods, made exclusionary trade agreements with other countries, and usually failed to pay their share of monies to keep the national government solvent. These and other practices, along with debtor’s riots and popular uprisings, ground the fledgling nation’s economy to a near-standstill (Bernstein 12).

When the delegates came together in 1787 to hammer out a solution to the economic and political mess that the country found itself, they had one chief overriding goal: make the central government stronger. In almost every area, the final product of the Constitutional Convention dealt with removing the states as the primary source of power in economic and military matters. In the Constitution, the national government, not the states, now controlled the national currency, the ability to make treaties with foreign nations (both trade and diplomatic), to raise federal revenue through taxation, to borrow money on the credit of the United States, to regulate intellectual property and interstate trade, to maintain tariffs and duties, and to maintain a standing national military to enforce order (all sworn to uphold the Constitution, which meant enforcing these restrictions on the states) (Bernstein, U.S. Constitution, Article I, Sec. 8-10).

With this newfound power, the regulation of commerce immediately took a sharp detour towards the central government (Government Regulation). States could still enter into international trade agreements, but the national government had the power to regulate them. States could still manage commerce within their own borders, but could not enact protectionist tariffs and duties against other states. These changes emboldened the elite trade factions, which had seen the hodge-podge of state regulations a hindrance to profit, and ensured the landed elites that popular uprisings like the recent Shay’s Rebellion would have less chance of starting, or if started, of causing them harm. Therefore, with the ratification of the Constitution of the United States of America, the stage was set for the next 220 years of federal government regulation of business.

Financial Regulation: Walls Go Up, Walls Come Down

The first century of the new United States saw little national interference in business affairs other than maintaining tariffs and guarding port traffic. By the end of the 19th Century, however, we begin to see the increase in regulation due to interstate commerce concerns, such as railroads, monopolies and trusts, and banking (Government Regulation). Although the 20th Century saw a sharp rise in regulation of almost every industry (from food processing to environmental concerns to labor), for the purposes of this paper the focus will turn to the financial sector and the constant battle between regulators and deregulators.

Beginning in 1863 with the National Bank Act, the federal government established a national banking system which permitted banks to operate subsidiaries that were "incidental to banking", essentially allowing banks to offer services beyond simply deposits and loans (Wilson). By the 1920’s, banks were involved in securities, investments, real estate, insurance, and a whole host of other financial dealings, with little direct interference from Washington. A few regulatory attempts were made, such as the 1927 McFadden Act which prevented banks from expanding beyond state lines (Wilson), but overall this free-for-all atmosphere of conglomeration and unregulated growth was spurred on by the financial and political elites of the day, exacerbated by the lengthy reign of Republicans in both Congress and the White House.

The stock market crash of 1929, the freezing of lending, the massive foreclosure rates, and the collapse of industries across the globe led directly to the Great Depression which lasted nearly a decade. The Great Depression (along with the public outcry from the widely-publicized investigations of the frauds and abuses by commercial and investment bankers) made these elites take a good hard look at what had led to the obliteration of all they held dear, and as reformist sentiment grew, called for protections in the financial marketplace (Hendrickson III, IV). Herbert Hoover, whose administration oversaw the entire debacle and did nothing constructive, passed this job over to Franklin Roosevelt and his strong Democratic majorities in Congress. With a broad sweep, Roosevelt pushed through regulations, infrastructure programs, and social-safety nets to help spur the economy and halt the decline (Government Regulation; Krugman).

The most important of these to the financial sector was the Glass-Steagall Act (Kaufman). This act forced banks to separate into commercial banking (deposits and loans) and investment banking (securities and other financial instruments), thereby protecting consumers and businesses from investment risks. Along with the creation of the FDIC in the Banking Act insuring the value of deposits, this provided a means for investors (who knowingly run the risk of losing everything to a bad investment) to be separate from non-investors (people and businesses who simply want a place to deposit their money and obtain loans). This greatly increased public confidence in the banks, resulting in the slow recovery of both lending and investment (Krugman).

For the next sixty-six years, Glass-Steagall was the primary source of stability in the financial services industry. Many other banking and investments regulations followed in the coming decades, including but not limited to: the 1956 Bank Holding Company Act, the 1960 Bank Merger Act, the 1977 Community Reinvestment Act, the 1978 International Banking Act, the 1980 Depository Institutions Deregulation and Monetary Control Act, the 1982 Banking Affiliates Act, the 1987 Competitive Equality Banking Act, the 1989 Financial Institutions Reform, Recovery, and Enforcement Act, the 1991 FDIC Improvement Act, and the 1994 Riegle-Neal Interstate Banking and Branching Efficiency Act (Wilson). All of these sought to regulate certain aspects of the banking and investments industry, to update regulations that were outmoded, or to provide deregulation in areas that were considered over-regulated.

Beginning in the late 1970’s, bank regulation reformers started pushing for deregulation of the financial industry. Many complained that they were unable to compete effectively with newer banks and investment firms, which had found loopholes in Glass-Steagall that the older firms were unable to utilize (Wilson). Others felt that Glass-Steagall was outmoded and that other regulations put in place in the intervening years provided adequate protections for banks to safely diversify (McTaggart). This upswell of deregulatory fervor was championed by conservatives in the Reagan years, but regulatory stalwarts prevented passage of any meaningful changes until the last years of the Clinton era. Finally, in 1999, Congress passed the Gramm-Leach-Bliley Act, effectively repealing Glass-Steagall and allowing banking, insurance, real estate, and investment firms to consolidate and introduce cross-industry products (McTaggart).

Essentially, this meant that under strict guidelines and regulatory controls, commercial banks could now combine with insurance companies, real estate developers could combine with securities firms, or any combination of the above. Over the course of the next decade, huge conglomerates began to form, just as they did in the lead-up to 1929. Despite the existence of regulations meant to prevent problems from developing, which were the primary justification for repeal of Glass-Steagall, the 21st Century saw a dramatic decrease in regulatory oversight and a dramatic increase in an inherent faith in the "corrections of the marketplace" under the Bush administration. Glass-Steagall was dead, Gramm-Leach-Bliley had torn down the fences, and the overfed cows of the financial industry were roaming freely in the corn. To top it off, the strong economic growth of 2002-2006 had led many to believe that turning the cows loose wasn’t any cause for alarm, and even reveled in the destruction of the fields. The events of 2007 and 2008 would rapidly change that view.

Laissez-Faire Capitalism Explodes (Again)

The first sign of trouble came in the form of sub-prime mortgages. Thanks to easy credit and the ability to roll these mortgages into securities which could then be traded as investments, commercial lenders (here in the United States, as well as around the world) began offering sub-prime mortgages at ever-increasing rates. Housing prices increased dramatically, sometimes five to eight times their original value, but that didn’t stop lenders from offering mortgages to less-than-qualified buyers. Everybody wanted to cash in on the housing boom, not thinking that for every boom, there is inevitably a bust. And bust it did, in 2007 (Becker, Stolberg & Labaton). An increase in defaults on mortgages led to tightened lending, but not before millions of homeowners were already in mortgages designed to increase in cost as the mortgage matured (so-called "adjustable rate mortgages"). This built-in failure mechanism assumed that a buyer could enter a mortgage, stay in the home for a few months, then re-sell and reap a huge profit as housing prices continued to climb. For many, this was true; it offered a ticket to homeownership and real financial power to those who got in at the beginning. For most, however, when prices began to fall, defaults only increased as consumers found they could neither sell for what they owed, nor keep up the increasingly-large payments. Millions lost their homes to foreclosure in 2007 and 2008, causing the value of the sub-prime mortgage backed derivatives to drop dramatically. As banks throughout the world were investing in these derivatives, often making them a huge part of their portfolios, banks began to file for bankruptcy, seek mergers, or fail outright (Blinder; Bailey, Litan & Johnson, 44-45). Credit ceased to flow, lending stopped, and the effects began to spread throughout the economy in every sector. Manufacturing, services, transportation, real estate, even state and local governments began to grind to a halt. It has begun to look like a repeat of 1929 (Krugman). To see that this is not an exaggeration, one need only know what the leading economist of at era had to say. In his article, "The Great Slump of 1930", John Maynard Keynes sounds ominously as though he is speaking of today’s events:

"At this moment the slump is probably a little overdone for psychological reasons. A modest upward reaction, therefore, may be due at any time. But there cannot be a real recovery, in my judgment, until the ideas of lenders and the ideas of productive borrowers are brought together again; partly by lenders becoming ready to lend on easier terms and over a wider geographical field, partly by borrowers recovering their good spirits and so becoming readier to borrow.

Seldom in modern history has the gap between the two been so wide and so difficult to bridge. Unless we bend our wills and our intelligences, energized by a conviction that this diagnosis is right, to find a solution along these lines, then, if the diagnosis is right, the slump may pass over into a depression, accompanied by a sagging price-level, which might last for years, with untold damage to the material wealth and to the social stability of every country alike." (Keynes, Pt. II)

These financial institutions had become "too big to fail", which was predicted by detractors of the Gramm-Leach-Bliley Act (Weissman). Hence, when they inevitably did fail, the only financial institution powerful enough to prevent them from taking down the entire economy was the federal government. One after another, failing institutions asked for help from the Federal Reserve. This led to the controversial "TARP" (Troubled Asset Relief Program) which was to dole out $700 billion to ailing banks for the purpose to loosen up lending and instill confidence bank into the banking system. As of Feburary 2009, $350 billion of the money has been given, largely without any controls or oversight, to banks with no appreciable result (Blinder). Adding bone-headed insult to our national injury, numerous reports indicate that banks and other institutions that received federal bail-out money used it to provide bonuses to executives, attend fancy retreats, spend lavishly on office redecorations, and other such bacchanalian pursuits. Public outrage at these reports is at a level not seen since the last Great Depression, and is causing political and financial elites to take public stands to curb these abuses (Angry). There is a great reluctance on the part of any politician, however, to bite too hard on the hand that feeds them (Kaufman).

Regulation, Deregulation and the Boom-Bust Cycle

What this demonstrates is that financial industry regulation which is prudent, efficient, transparent, and especially well-overseen by attentive regulators and outside watchdog groups to ensure compliance, leads to economic stability for the entire country, and by extension, the world. It also demonstrates that regulation that is lax, non-existent, uncoordinated, or poorly overseen leads to economic instability and events such as the current financial meltdown. At the very least, we can extrapolate that poor regulatory efforts leads to more violent boom-bust cycles in various industries, as in the most recent case of housing. Greater financial industry regulation is needed, but it should be designed to meet the needs of 21st Century technology and globalization realities. As we have seen, over-regulation leads to calls for deregulation, which if done precipitously can lead to drastically dangerous economic outcomes when externalities are ignored, dismissed, or overlooked. The financial industry must be returned to a modernized version of the Glass-Steagall Act, with much more streamlined ability for institutions to merge, diversify, grow, and prosper in a globalized world; however, they must also be placed under extremely strict controls to prevent over-securitization, over-leveraging, and the creation of complex derivatives (Bailey, Litan & Johnson, 44-45).


Regulation of commerce has followed civilization from its earliest days. The major failing of the Articles of Confederation was that it lacked any central authority on regulatory matters. This was rectified in the Constitution, with the establishment of a strong central government with the ability to regulate commerce in all aspects of national policy. Over time, the national government gained greater and greater influence over the regulation of commerce, especially the financial industry. With the inept failure of the government to regulate investment firms and banks leading directly to the stock market crash of 1929, the Glass-Steagall Act and other legislation and regulations aimed at the financial industry were enacted to shore up public confidence and restore the economy. Over the next sixty-six years, along with other regulations, the Glass-Steagall protected the economy from another outburst of "too big to fail" institutions; however, with its repeal and the adoption of the Gramm-Leach-Bliley Act, the way was cleared for the creation of mega-mergers and consolidations of unprecedented scale between commercial banking, investment banking, real estate, and insurance firms. The combination of cheap credit and the securitization of sub-prime mortgage assets led to an artificial housing boom, which collapsed in 2007. As millions of homes began to fall into foreclosure, and these "assets" soon became worthless, the "too big to fail" started to go under, and the cries of wrath and doom began. Left with no alternative, the U.S. government agreed to bail these hat-in-hand companies out to the tune of $700 billion, but so far there has been little activity seen other than massive abuses of the top-level executives and complete lack of transparency as to where the money has gone. In the end, the lesson we have learned is that regulation, whether financial or otherwise, if left to the "corrections of the marketplace" or lax oversight nearly always result in disaster or at least severe boom-bust cycles; therefore, tough but fair regulation with consistent oversight, modernized for the 21st Century, is the tool that needs to be implemented with the financial industry (and by extension, all other industries) from this day forward.

Works Cited

"Angry senator wants pay cap on Wall Street 'idiots'." January 30, 2009. January 30, 2009. LINK.

Bailey, Martin N., Robert E. Litan and Matthew S. Johnson. The Origins of the Financial Crisis. (November 2008). Brookings Institution. December 20, 2008 LINK.

Becker, Jo, Sheryl G. Stolberg and Stephen Labaton. "White House Philosophy Stoked Mortgage Bonfire." The Reckoning. The New York Times December 21, 2008. January 26, 2008 LINK.

Bernstein, R. B. (Introduction). The Constitution of the United States, with the Declaration of Independence and the Articles of Confederation. New York: Barnes & Noble, 2002. Print.

Blinder, Alan S. "Six Errors on the Path to the Financial Crisis." Economic View. The New York Times (January 25, 2009).January 25, 2009 LINK.

Feulner, Edwin J. "Regulated to death. (government regulation of business) (Above the Beltway)." Chief Executive (U.S.) n85 (May 1993 n85): 14(2). Academic OneFile. Gale. National University Library System. January 25, 2009 LINK.

Gilb, James. LMSC, LAN/MAN Standards Committee (Project 802). n.d. January 25, 2009. LINK.

"Government Regulation of Business." Encyclopedia of American History. Answers Corporation, 2006. January 27, 2009. LINK.

Hendrickson, Jill M. "The Long and Bumpy Road to Glass-Steagall Reform: A Historical and Evolutionary Analysis of Banking Legislation. (Other Articles)." The American Journal of Economics and Sociology 60.4 (Oct 2001): 849(31). Academic OneFile. Gale. National University Library System. January 26, 2009 LINK.

Kaufman, William. "The Bi-Partisan Origins of the Financial Crisis: Shattering the Glass-Steagall Act." Opinion. CounterPunch (September 19, 2008). January 26, 2009. LINK.

Keynes, John M. "The Great Slump of 1930." London: The Nation & Athenæum, December 20 and December 27, 1930 (First Edition). Project Gutenberg Canada ebook #197 produced by Dr. Mark Bear Akrigg, 12 November 2008. December 20, 2008. LINK.

Litan, Robert. "Regulation." The Concise Encyclopedia of Economics.2008. Library of Economics and Liberty. January 27, 2009. LINK.

McTaggart, Timothy R. "Financial Services Modernization Legislation: One for the Century, If Not for the Ages." Bank Accounting & Finance 13.2 (Winter 1999): 31. Academic OneFile. Gale. National University Library System. January 26, 2009 LINK.

Weissman, Robert. "Deregulating Finance." Multinational Monitor (Oct 1999): 6. Academic OneFile. Gale. National University Library System. January 26, 2009 LINK.

Wilson, Gregory. "Getting beyond Glass-Steagall." The McKinsey Quarterly n2 (Spring 1995 n2): 108(8). Academic OneFile. Gale. National University Library System. January 26, 2009 LINK.

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