To restore financial stability, bring back Glass-Steagall

Governments around the world have authorized $11 trillion of fiscal programs to mitigate the economic and social fallout from the COVID-19 pandemic. Those programs will cause sovereign debt burdens to exceed 100 percent of global GDP by 2021, surpassing the record set during World War II. Central banks have supported government spending and stabilized financial markets by purchasing $6 trillion of government bonds, corporate debt and other assets.

Governments and central banks have essentially repeated their extraordinary responses to the global financial crisis of 2007-09, but at a faster pace and with an even broader scope. Central banks have injected huge amounts of liquidity into the financial markets to help borrowers and prevent failures of systemically important financial institutions. Central banks have pushed interest rates to record lows, thereby encouraging investors to purchase corporate bonds, equities and other risky assets. By inflating the values of speculative investments, central banks have aggravated deeply troubling inequalities in wealth and income between the most affluent members of society and everyone else. 

The global response to the pandemic confirms that we have not solved the problems that brought us the Great Recession more than a decade ago. The world remains trapped in a “global doom loop” in which governments and central banks must ensure the survival of “universal banks” (banks that engage in capital markets activities) and “shadow banks” (large nonbank financial institutions such as private equity firms, hedge funds, insurance companies and mutual funds). Central banks must buy troubled financial assets to ensure the stability of financial markets and forestall threats to the survival of financial giants. Meanwhile, financial giants underwrite rapidly rising levels of debt for governments, businesses and households.

The global doom loop has created a menacing overhang of public-sector and private-sector debts. Total global debts have grown by more than 50 percent between 2007 and 2020. The ratio of global debts to global GDP reached 331 percent in March 2020, an all-time record.

The accelerating rise of global debts over the past two decades has produced an infernal cycle of debt-fueled booms followed by painful busts, each of which must be “contained” by interventions from governments and central banks. Each new intervention creates a greater sense of complacency among investors, thereby promoting a larger and even more threatening boom. Sooner or later, governments and central banks will not be able to “contain” the explosion after a boom, and another Great Depression could occur.

To break the global doom loop and restore financial stability, we must adopt a new Glass-Steagall Act. The original Glass-Steagall Act of 1933 supported stable financial markets and prevented systemic financial crises for more than three decades after World War II. Glass-Steagall separated banks from the capital markets and prohibited nonbanks from accepting deposits. It established risk buffers that prevented financial disruptions occurring in one sector of the financial markets from spreading to other sectors and triggering systemic crises. Regulators could respond to problems arising in one sector without being forced to bail out the entire financial system. Regulators could also encourage strong financial institutions in one sector to support troubled institutions in another sector. The undermining and repeal of Glass-Steagall’s prudential buffers helped to ignite the subprime mortgage boom that led to the Great Recession. 

A new Glass-Steagall Act would greatly improve financial stability.  It would prevent banks from using government-protected deposits to finance speculative trading in the capital markets. It would prohibit banks from underwriting securities other than government bonds. It would stop nonbanks from offering short-term financial instruments (like money market mutual funds) that masquerade as “deposits” but are not covered by deposit insurance and other banking regulations.

A new Glass-Steagall Act would reestablish risk buffers and prevent contagion across financial sectors. It would improve market discipline by preventing banks from transferring their public subsidies to affiliates engaged in capital market activities. Regulators would no longer be compelled to prop up securities markets because of concerns about massive securities exposures held by banks. Shadow banks would shrink substantially, as they could no longer finance their operations with short-term financial instruments. Bank regulators could more effectively monitor and control levels of short-term claims in financial markets because those claims would be issued only by banks.

A new Glass-Steagall Act would create a more diverse and competitive banking system by breaking up universal banks. Banks would return to their traditional roles of providing deposit, credit, fiduciary and payment services to businesses and consumers. Banks would have much stronger incentives to serve all segments of business and society, instead of focusing their efforts on Wall Street speculators, multinational corporations and the wealthy.

Securities markets would once again become true markets because they would not be linked to the fortunes of “too big to fail” universal banks and shadow banks. Our political, regulatory and monetary policies would no longer be held hostage by financial giants. Banks and securities firms would return to their proper roles as servants – not masters – of commerce, industry and society.

In 1914, Louis Brandeis warned the American public, “We must break the Money Trust or the Money Trust will break us.” Congress acted on his advice in 1933 by enacting the Glass-Steagall Act. Brandeis’s warning is just as timely today as it was in 1914 and 1933. 

Arthur E. Wilmarth, Jr. is a professor emeritus of law at George Washington University in Washington, D.C. This op-ed is based on his book, “Taming the Megabanks: Why We Need a New Glass-Steagall Act (Oxford University Press),” which will be published on October 2.