Did Repealing Glass Steagal Really Matter and Is the Fed Really Protecting Us From Europe?

Got an article and blog post over at Mises Canada today.  Here is an excerpt from the article entitled "Did Repealing Glass-Steagal Really Matter?"

The financial crisis was caused primarily by the sharp decline in value of housing and once-AAA rated mortgages backed securities that garnered profitable yields. It was the Fed-induced bubble and subsequent burst that wreaked havoc on big bank balance sheets; not the crumbling of the barrier between two institutions that virtually performed the same functions of issuing commercial paper and investing in securities. By citing GS, proponents of financial regulation put the cart before the horse by not addressing the true cause of the bubble. After all, Bear Sterns and Lehman Brothers, both of whose collapse induced the 2008 crisis, were investment banks only as noted by David Leonhardt of the New York Times.ⁱ For the amending GS theory to work, one would have expected to see both Lehman and Bear Sterns using demand deposits of their commercial banking accompaniments as collateral for risky mortgage lending. That is the narrative, is it not?

In their recent book “Engineering the Financial Crisis,” Jeffrey Friedman and Wladimir Kraus back up Leonhardt’s assertion by noting that if the GS explanation were plausible, investment banks needed to transfer their losses to their affiliated commercial banks under the same holding company. Under the provisions of Gramm-Leach-Bliley however, commercial banks are not affected by the losses of their investment banking counterparts. According to Friedman and Kraus,

“Under GLBA, a bank holding company is merely a shareholder in its affiliates; it has no liabilities for their debts, and if either an investment-bank subsidiary of a BHC (bank holding company) or the BHC itself fails, the commercial banking subsidiary is unaffected.”ⁱⁱ

Interestingly enough, Canada had no form of Glass-Steagal and its banking system didn’t see as intensive of a downturn as the U.S.’s. In fact, many countries don’t have a divide between commercial and investment banking. Indeed, it would seem like the invocation of Glass-Steagal is nothing more than a desperate attempt by government interventionists to find a slightly relevant regulation to grasp on to and wave around. Even if GS hadn’t been amended, former Federal Reserve chairman Alan Greenspan’s unprecedented dropping of interest rates in the early 2000’s most likely would have occurred anyway; hence setting the foundation for an unsustainable asset bubble. Government regulation, no matter how substantive and strictly enforced, will always be avoided by profit seekers forever looking for more lucrative opportunities. Even the murder and violence that plagued communist Russia didn’t prevent a black market from emerging and flourishing.

And here is my post from today:

At least that is what economist Tyler Cowen argues in his recent New York Times column.  Due to the unprecedented increase in excess reserves held by banks, Cowen claims that the Federal Reserve has provided a nice cushion for threat a destabilized Europe might bring:

Starting in late 2008, as a response to our financial crisis, the Fed bought government and mortgage securities from banks on a very large scale.Bank reserves at the Fed rose from virtually nothing to more than $1.6 trillion. Then the Fed paid interest on those reserves to help keep them on bank balance sheets.
It is estimated by Moody’s that America’s biggest banks now have liquid assets that are 3 to 11 times their short-term borrowings. In other words, it’s the cushion we’ve been seeking. Furthermore, a lot of those reserves sit in the American subsidiaries of large foreign-owned banks, protecting the European system, too.

THE Fed’s stockpiled liquid reserves have met some heavy criticism. Hard-money advocates contend that they are a prelude to hyperinflation — although market forecasts and bond yields don’t bear this out — while proponents of monetary expansion have wished that banks would more actively lend out those reserves to stimulate the economy. That second view assumes that the financial crisis is essentially over, but maybe it’s not. As the euro zone crisis continues, it seems that Ben S. Bernanke has been a smarter central banker than we had realized.

Cowen is right about one thing, just take a look at excess reserves sitting on the sidelines at the Fed, via FRED:

Calling Bernanke, who’s widely praised scholarship amounts to nothing more than a childlike fear of deflation, a smart central banker is protesting too much.  If anything, Bernanke’s incredible liquidity injection was sheer dumb luck as it now provides a nice buffer from the EZ.  But then again, any promise to print on demand ultimately provides a backstop for banking crises.  Why should large financial institutions fret about  losses in the long run when their balance sheets have a direct line to the printing press?  This question is never answered by central banking proponents.

Even so, Bernanke’s “Man of the Year” solution wasn’t actually a solution at all.  It was simply another shot of high-grade heroine to stave off the after effects of the previous bout of low interest rate fueled gorging.  It prevented the rotten mortgage debt, the by-product of the housing bubble, from being liquidated.  Losses that should have happened didn’t.  One day they will be realized but hopefully we will all be “dead” by then; just as Keynes hoped.  Future generations will end up having the bill passed to them.

Cowen mentions that central banking “is the most powerful and most influential financial regulator..”  He is correct but surprisingly doesn’t make the connection that central planning is exactly what got us into this mess.  Central banks have no other tools at their disposal besides printing money.  If printing money to suppress interest rates got us here, why would it ever get us out?  It’s kind of like when former Treasury Secretary Lawrence Sumner declared:

The central irony of a financial crisis is that while it is caused by too much confidence, borrowing and lending, and spending, it can be resolved only with more confidence, borrowing and lending, and spending.

Can these guys be any more Orwellian?

While Bernanke’s great showering of liquidity may provide some protection from Europe, it’s just one of many unintended consequences such a policy brings.  Turning the printing press on its “high” setting and paying banks not to lend in order to control inflation took no real talent.  Bernanke will only prove his worth as central banker if he is able to wind down the Fed’s balance sheet ultimately without sparking another recession.  Judging by his past record of deflation fear mongering, let’s just say I am skeptical of his willingness to do it.