Plain Sense Economics

Financial and business news over the last week has focused on the rapid departure of two CEOs – Stan O’Neal with Merrill-Lynch and Charles Prince with CitiGroup. Each was tarred with unexpectedly large losses in the investment activities of their respective organizations. In very broad terms these losses are in the billions of dollars.

In my principles of macroeconomics class last week and this we’ve been reviewing the events that led up to the Great Depression and some of the conditions that triggered that slide into the abyss. One of the precursor conditions was commercial banks who held securities (stocks) in other companies, rather than directing most of their assets to loans and cash. The stock market craziness of the late 1920s led to many individuals committing their life savings into a “can’t lose” investment strategy. Unfortunately, normally staid, conservative banks did the same thing. When the stock market collapsed in October 1929, the paper wealth of both individuals and banks vanished.

For the banks this meant they had insufficient assets to back the deposits customers had left with them. Coupled with the generally hard times and individuals trying to retrieve their savings and bank balances, banks that were in this precarious asset position failed.

Senator Carter Glass and Congressman Henry Steagall co-sponsored the Banking Bill of 1933 (actually the second banking bill associated with their names.) Among other things the bill (which is generally referred to as the Glass-Steagall Act today) prohibited commercial banks from investing in securities or engaging in investment bank activities. Regular, commercial banks could no longer buy stocks and other securities of other companies, nor could they purchase new releases of securities for resale to the public (the traditional role of an investment banker.)

This firewall between commercial and investment banking remained in place until 1999, when the Gramm-Leach-Bliley Act was signed by President Clinton. After more than six decades of efforts by the banking industry to weaken or repeal Glass-Steagall, the efforts finally paid off.

So, here we are in 2007. Large financial conglomerates like Merrill-Lynch and CitiGroup have become successful. They have a complicated collection of commercial banking and investment banking functions, and are heavily into investing in general. The one-two punch from the housing slow-down and the sub-prime credit crunch are stressing these two companies and others like them. The size of their investments and the concentration of risk are sufficient to make policymakers take notice. We should as well.

So, have we learned from past lessons? On the surface, at least, it appears not. Glass-Steagall was a response to a series of bad decisions on the part of bankers. Today’s generation of bankers prefer a more flexible regulatory environment. In essence they want the freedom to repeat past mistakes. As a card carrying economist I should favor the disciple exacted by the market – with poor decisions punished and good decisions rewarded. On the other hand, the strength, confidence, and stability of our banking system is really a national concern, and I wonder how much we should trust those in charge of these mega institutions.