The Other Glass-Steagall: The FOMC And The FDIC

Democratic presidential aspirants Bernie Sanders and Hillary Clinton have dueling financial reform plans. Sanders wants to resurrect the Glass-Steagall Act; Clinton opposes the idea.

Sanders thinks the repeal of Glass-Steagall caused the 2008 financial crisis. Clinton denies it.

As I wrote in October, one problem with the theory that “repeal of Glass-Steagall caused the financial crisis” is that the Act never was repealed.

The Banking Act of 1933, aka Glass-Steagall, contains 34 sections. Only four of those sections implemented the so-called separation of commercial and investment banking, but many casually refer to this separation as the Glass-Steagall Act (or, just Glass-Steagall).

Either way, the 1999 Gramm-Leach-Bliley Act (GLBA) only repealed two of those four sections.

It’s also incorrect to say that Glass-Steagall erected the “high wall between high-risk trading and boring banking” that Senator Elizabeth Warren (D-Mass.) and so many others perceive. All four of the above referenced sections had exceptions to the activities they prohibited, and the bill purposely left many financial activities’ legality open to interpretation.

The debate we should be having is whether we would have been better off if the GLBA had actually repealed the Glass-Steagall Act. The remaining sections deserve much more scrutiny than they get.

Section 8, for instance, created the Federal Reserves’ Federal Open Market Committee (FOMC) and authorized the creation of the Federal Deposit Insurance Corporation (FDIC).

At first, the FOMC consisted of 12 members—one appointed by each of the 12 District Federal Reserve Banks. Senator Glass, a “champion and a co-founder of the Federal Reserve,” didn’t like that individual District Banks decided to conduct open market operations – risky (in his view) bond buying – on their own.

In the Senate on May 9, 1932, Senator Glass lamented (page 9884 of the Congressional Record):

"Not only has the Federal reserve banking system been used in an inordinate measure in stock-market transactions but there appears to have been an extraordinary misconception by the administrators of the act of its real purpose.

The whole purpose of the [Federal Reserve] act was to enable a member bank of the system, when it should have depleted its own liquid and ready resources in responding to the requirements of commerce and agriculture and industry, to take its eligible paper to its Federal reserve bank and get additional funds."

Glass was a staunch advocate of the real bills doctrine. He believed the only legitimate form of credit was that which was backed by commercial activity. He abhorred what he viewed as purely speculative securities investments.

For at least some of its founders, this doctrine was the foundation for the Federal Reserve Act. The Fed’s discount window was its testament.

Banks would lend (discount) to commercial businesses and be repaid later, possibly after those businesses were paid. In the meantime, should the bank’s funds run too low, they could take their eligible paper (loans) to their Fed district bank for re-discounting. That is, the Fed would lend them money based on the banks’ commercial lending.

Glass went on to say:

"What has happened? The rediscount feature of the system has practically been submerged by the open-market transactions in the large money centers, somewhat speculative, altogether of an investment nature, totally, I contend, unrelated to what were intended to be the normal operations of this great banking system."

Similar remarks can be found in Senator Glass’ 1931 hearings.

Section 8 of the Glass-Steagall Act states that “No Federal reserve bank may engage in open market operations except in accordance with regulations of the Federal Reserve Board.”

It is perhaps one of the great ironies of history that Glass – if we’re to take him at his word – tried to prevent the creation of a true central bank by empowering a government board to oversee the District banks’ open market operations. He was mistaken, but he thought the board would keep the District banks focused on the discount function.

To his credit, Glass later opposed the Banking Act of 1935, the bill that basically finished relegating the District Banks’ relevance to the background of the Federal Reserve System. (It appears he realized it wasn’t quite working out, but a pragmatist would wonder what Glass thought was going to happen after he created the Washington-based Board in the first place.)

Would we be better off if the Fed had remained a decentralized sort of reserve association, as Glass seems to have intended? Conventional wisdom says that the Fed has stabilized the economy compared to the pre-Fed era, but there’s ample evidence to cast doubt on that proposition.

And what about the FDIC? It’s often assumed to be indispensable, but maybe it’s time to rethink this Glass-Steagall fixture as well?

Rep. Steagall was the driving force behind federal deposit insurance, and there would have been no Glass-Steagall separation of commercial and investment banking unless Senator Glass agreed to go along with the FDIC provision.

This was a contentious decision – the FDIC provision even drew veto threats from President Franklin D. Roosevelt. President Roosevelt himself recognized the moral hazard that would come with taxpayer-backed deposit insurance. In a 1932 letter to the NY Sun shortly before his election, Roosevelt wrote:

It would lead to laxity in bank management and carelessness on the part of both banker and depositor. I believe that it would be an impossible drain on the Federal Treasury to make good any such guarantee. For a number of reasons of sound government finance, such plan would be quite dangerous.

The bill passed anyway and, of course, included the FDIC provision. The amount insured started at $2,500 (about $45,000 adjusted for inflation), but it was raised several times and now stands at $250,000 per account.

The average transaction account (checking, savings, money market, and call accounts) balance is only about $4,000, so it’s pretty difficult to argue the $250,000 limit protects the little guy.

Regardless, economists have long shared FDR’s concerns, and raising the amount covered is exactly the wrong way to fight “laxity” and “carelessness on the part of the both banker and depositor.”

Why not lower the amount covered, and require banks to obtain private deposit insurance?

Switzerland and Germany have largely privatized their deposit insurance systems. According to the World Bank, 87 countries have explicit deposit insurance, and (as of 2003) 21 of them have some form of private co-insurance requirement as part of their system.

Besides, a great deal of research shows that countries with more government involvement in a deposit insurance system, combined with higher levels of coverage, tend to have more bank failures and financial crises.

So by all means, let’s debate whether the Glass-Stegall Act was necessary. But let’s start with Section 8.

Norbert J. Michel is a research fellow specializing in financial regulation for The Heritage Foundation’s Thomas A. Roe Institute for Economic Policy Studies. He is also a co-author of Heritage’s Opportunity for All; Favoritism to None”

This piece originally appeared in Forbes and can be viewed in full at http://www.forbes.com/sites/norbertmichel/2016/01/11/the-other-glass-steagall-the-fomc-and-the-fdic/#2715e4857a0b320d81de4f3e

About the Author

Norbert J. Michel, Ph.D. Research Fellow in Financial Regulations
Thomas A. Roe Institute for Economic Policy Studies

Originally appeared in Forbes Norbert J. Michel is a research fellow specializing in financial regulation for The Heritage Foundation’s Thomas A. Roe Institute for Economic Policy Studies. He is also a co-author of Heritage’s Opportunity for All; Favoritism to None”