The Shocking True Story of Glass-Steagall and How It Made Me a Believer

Sen. Elizabeth Warren, D-Mass., welcomes Securities and Exchange Commission Chairman Mary Jo White.

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The furiosity and insistence with which proponents of stricter financial regulation have denounced the 1990s-era repeal of the Glass-Steagall ban on letting a single entity house both commercial and investment banking has long puzzled me. Combining these operations had nothing in particular to do with the Great Depression, it had nothing in particular to do with the 2007-2008 banking crisis, and dozens of other things happened in the regulatory world that you could focus on. But I recently read an old article by Alex Tabarrok (PDF) in the Quarterly Journal of Austrian Economics that reveals the reason the act was enacted in the first place and that turned me into a believer.

Don’t get me wrong. Tabarrok himself is no proponent of Glass-Steagall, and the article is no case for the law. It follows the somewhat tedious formula of a lot of “public choice” (i.e., “political economy” but when done by a political conservative) scholarship of acting as if the exposé that the politicians and regulators behind some given move weren’t pure as the snow itself constitutes a policy argument. But it’s extremely informative and sheds some much-needed light on where this rule came from, and how you might imagine getting the banking sector back under wraps.

The basic story is that the Depression led to a lot of public outrage about the financial system and the outrage was—as outrage tends to be—a little bit inchoate and not really focused on the fine-grained details of public policy. Meanwhile, the Rockefeller family and the Morgan family had some long-standing business conflicts between their respective empires. And the Glass-Steagall bill was essentially an effort by the Rockefellers to channel that inchoate public outrage in a direction that would harm the Morgans:

More than anyone else, Winthrop Aldrich, representative of the Rockefeller banking interests, was responsible for the separation of commercial and investment banking. With the help of other well-connected anti-Morgan bankers like W. Averell Harriman, Aldrich drove the separation of commercial and investment banking through Congress. Although separation raised the costs of banking to the Rockefeller group, separation hurt the House of Morgan disproportionately and gave the Rockefeller group a decisive advantage in their battle with the Morgans.

Tabarrok notes that when this kind of regulatory strategy is pursued in a given industry, “the industry as a whole will shrink” even while one firm gains an advantage over its rivals. And here we have actually an answer to a question that’s troubled me for years: How, given political realities, can the financial sector ever be brought to heel? After all, it’s not going to stop being the case that lobbyists have a lot of influence over the legislative process or that the costs of bank regulation are concentrated and the benefits are diffuse. Under the circumstances, I’ve found it difficult to tell a plausible story in which there’s sustained effective bank supervision and some reversal of finance-friendly industrial policy and the hypertrophy of the financial services sector.

This story about Glass-Steagall and cost-raising strategy gives me hope. It shows a way that smart and savvy would-be regulators can find ways to undermine sector-level political solidarity. Not just in ways that favor one firm against another (which would be pointless) but even in ways that shrink the sector as a whole.