From the Great Depression to the 2008 Global Financial Crisis

"Stock prices have achieved what appears to be a permanently high peak," declared Irving Fisher (1930). The result was the most severe economic downturn in history. Mishkin and Eakins (2009) stated that "during the slump, over 10,000 banks failed". As a result, the Glass-Steagall Act was passed, which separated commercial banking from investment banking. The Glass Steagall Act made it illegal for a commercial bank to buy or sell securities on behalf of its customers. This Act was enacted to describe provisions in the U.S Banking Act of the year 1933 which limited activities, securities and affiliations within security firms and commercial banks (Wilmarth, and Arthur, 2008, p. 559–645).

The aim of the act was to prohibit commercial banks from being part of the business of investment banking. The primary objective of the Act was twofold, have Americans public confidence in the banking system restored and stop unparalleled run on banks. One of the famous regulations of the Act was Regulation Q which prohibited commercial banks from payment of interests based on demand deposits (Ruebling, 1970). The Act had been sponsored by a former treasury secretary, Senator Carter Glass and Senator Henry Steagall who was a chairman committee of the House Banking and Currency. The passage of the Act was aimed to counter the Great Depression which had experienced more than 5,000 banks fail. However, the potency of the Act was lost in subsequent years and this informed its repealing in 1999 (Crawford, 2011, p. 127-132).

A study by Mishkin and Eakins (2009) found that the Act performed reasonably well up until the late 1950s. It became “troublesome” during the 1970s and 1980s “when inflation pushed short-term interest rates above the level that banks could legally pay”. These findings were supported by Minsky (1982, p. 5-13) who noted that inflation had caused financial instability and that the actions dealt by the Federal Reserve board controlled it through engineering “credit crunches” to fight inflation. Robert and Lucas (2013) also were of the view that inflation played a significant role in the failure of the Act. The Act had various flaws one of which, as argued by many economists, was Regulation Q - the prohibition of paying interest on demand deposits. Two studies by Friedman (1969) and Tobin (1969) examined how Regulation Q affected ceiling rates. These researches concluded that inflation and aggregate output were mostly unaffected by regulation Q. Soon after, ceiling rates proved useful as assistance to housing. Tobin (1970, p. 301-317) stated that the foremost reason for the regulation was to allow undistributed profits to rise at loans and savings. However, Meltzer (1974, p. 763-777) claimed that there was no any positive effect of Regulation Q towards housing. Meltzer (1974) found that the effect on mortgages was encouraging, though not housing. Lucas Jr (2013, p. 43-47) argued against Regulation Q stating that the ban of interest payments on checking accounts was unjustified and simply uneconomical. Friedman (1972) stated that “the fed’s insistence on keeping Regulation Q ceilings at levels below market rates had simply imposed enormous structural adjustments and shifts of funds on the commercial banking system for no social gain whatsoever”.

The Glass-Steagall Act unsuccessfully attempted to reestablish banking traditions since it controlled the symptom of the Great Depression instead of the core foundation of the crisis (interest rate volatility). It was not until the 1980s when the regulators recognized “that every regulation offered an opportunity to profit from circumvention. Although regulators and congress were not ready to repeal the Glass-Steagall Act, they began to move in that direction”. The board of governors of the Federal Reserve “asked congress to permit holding companies to underwrite municipal revenue bonds, mortgage backed securities, commercial paper and mutual funds”. The first steps to the separation of commercial and investment banks were taken. In 1999 the Clinton administration repealed the Glass-Steagall Act (Crawford, 2011, p. 127-132).

Scholars have argued that the Glass-Steagall Act was not necessarily in the first place. Garten (1989) states that “the banking industry’s problems in the 1930s, or any other time, were caused by participation in investment banking activities was debatable.” If defending Glass–Steagall in the 1930s was “debatable”, it is simpler to claim that Glass–Steagall served no genuine resolve when the difference amongst commercial and investment banking activities had been distorted since the 1960s. However, Dale (1992) predicted a financial collapse as a result of combining commercial and investment banking. In 2008 he claimed that “the mixing of banking and non-banking activities has had three destabilizing effects”, first of which eliminated global barriers - “financial shock can therefore be transmitted more easily around the globe”. Second was that “it allowed the moral hazard problem to be extended to banks non-bank activities” which he feel can lead to “catastrophic destabilization”. Lastly he claimed “fusion of banking and securities activities” could lead to a “cultural clash which different time horizons”. Meltzer, (2009), argues that the Act “took 60 years to unravel and in the process created serious inefficiencies in the US banking system”.

Economists regularly argue on the implications of the repeal on the Glass-Steagall Act toward the 2007/08 Global Financial Crisis. In an interview Ben Barnanke stated that the Act was “pretty irrelevant” to the crisis since many banks such as “Wachovia” suffered due to making “bad loans” and “you had investment banks like Bear Stearns and Lehman that went bad because of their investment banking activities, even if the Act was still in place at the time of the financial crisis it would have had no effect on most of these firms”. However, it is argued that “a new separation between commercial and investment banking would clearly create distortions; but would address deep public concerns, and would rebuff damaging attacks against wider benefits of the market economy”. Meltzer (2009) strongly disagrees with this view and claims “no other country in the world separates commercial and investment banking, and none of them have problems on that account”.

Kregel (2010) studied the possible restoration of Glass-Steagall type legislation as a means of restoring single-function financial institutions. The findings of this research was that the historical process that led to the breakdown of the original Glass legislation was driven by financial innovations in the financing process which led to an increase in the blending of activities of commercial deposit banks with securities market investment banks (Kregel 2010). Thus, any attempt to separate the two activities extremely costly to the entire economic system. On the other hand, a study by Lucas Jr, (2013, p. 43-47), seeks to find out the factors that influenced the failure of the Act. Lucas Jr, (2013, p. 43-47) argues that it was the interaction of Regulation Q and the US inflation of the 1970s that drove business deposits out of the regulated commercial banks and into substitute forms of liquidity, possibly setting the stage for the liquidity crisis of 2008. According to Lucas Jr, (2013, p. 43-47) if the financial crisis of 2008 had not occurred the framework of the Act might have served for another 66 years.

PROJECT PLAN

There lacks much research on the effectiveness of the Glass-Steagall Act in relation to economic performance, as much discussion has been directed at specific flaws and benefits that the Act had on the banking industry. Rather than focus on just the banking industry alone, this paper will focus on the effect that the Act had on the economy as a whole. This will be achieved by looking at time-series data related to GDP, through deep analysis this paper will attempt to justify how the Glass-Steagall Act contributed to changes in GDP. Additionally, the paper will argue on the effectiveness of economic models in prevention of economic crisis. It has been argued that financial economic models crash with a financial crisis (PW, 2014). This paper will seek to explore this phenomenon.

Since one of the Glass-Steagall Act’s main purposes was to reduce the risk imposed on consumer deposits, this paper will also use time-series data to compare customer confidence in banks throughout the early 1930s up until the end of the more recent Global Financial Crisis. Customer confidence will be calculated by levels of deposits, withdrawals, loans and savings made by customers during the years that the Glass-Steagall Act was in place, it will use data from the five largest commercial banks in the US. The most significant confounding factor that will have to be controlled will be the time and age factor. The limitations may be that this data will be difficult to gather, also in order to obtain realistic figures changes in population and external factors must be taken into account when calculating the figures.

REFERENCES

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