Mortgage Crisis – The Glass-Steagall Myth

Posted by Jason | Posted in Economics, Government | Posted on 26-10-2009

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Since the mortgage crisis began, the left has used the repeal of the Glass-Steagall act as a battering ram to break down the pro-free market argument. The left, the media and even some conservative politicians claim it was not having enough regulation that caused the mortgage crisis and ultimately the economic melt down that we are currently experiencing.

This really is a silly argument on its face. How does removing an act, which separates commercial and investment banking, cause risky behavior? Causation is what the statists are claiming. This would be like saying removing a guard rail is what caused me to drive off the road and into a tree. I’m sure we can all agree, it wasn’t the guard rail. It was my reckless driving. Similarly, it wasn’t the removal of the Glass-Steagall act that caused the current mess, it was the risky behavior. But, why was there risky behavior? Why would I drive off the road and hit a tree? Something must influence these actions.

In the case of driving off the road and hitting the tree, maybe I was drinking, or maybe the speed limit sign said 100mph. Both of these influences would be considered the the causes, would they not? Also, by the standard of the left, removal of the guard rail would cause every driver to drive recklessly and hit the tree. If all drivers fly off the road and hit the tree, surely there must be something that causes them to do so. It would have to be a 100mph sign heading into a blind bend, or maybe a mandatory rest stop where all must fill up on liqueur before heading back down the road. Either way, both would cause the reckless behavior.

Similarly, in the mortgage crisis, something influenced the behavior of the entire market. Bankers didn’t wake up one day and say, “Hey, let’s be really risky.” Bankers were enticed into being risky by the government. The government encouraged the risky behavior with artificially low interest rates by the Fed and legislation (ie. regulation) by congress that was trying to promote so called affordable housing. “Everyone should own a home” was the mantra of the past decade.

First, the government and community organizing groups through their power of controlling and influencing how banks operate forced the banks to lend to borrowers that would otherwise be deemed risky. This was not just the left. The Bush administration jumped on board with similar pushes. Fannie Mae and Freddie Mac’s purpose was to push affordable housing, and they are the ones who basically establish the market in which bankers operate. Who do you think created the mortgage backed security instrument of which this monster was created?

Second, another part of the Glass-Steagall act that everyone forgets, but which everyone loves is the establishment of the FDIC. While it may seem like an excellent idea, how does saying, “Don’t worry. If you fail, the government will bail out your depositors.” effect behavior. Would that not increase risky behavior, knowing that you cannot harm the customers? Doesn’t that make customers less critical of who they deal with for their banking knowing that they have nothing to lose?

Third, the Federal Reserve artificially lowered interest rates to a historic low, reaching a negative real interest rate. In order to lower the interest rate, the Fed increase the money supply and encourages the banks to push out that money via loans. The whole point of this is to cause an expansion in the economy. Well, we got an expansion alright. As, Thomas Sowell says, “You can open the flood gates, but you can’t control where the water goes.” In this case, the water went into real estate. One could argue that the government did control the water somewhat with their push for affordable housing and their everyone should own a home legislation.

Another problem for the statists argument is if the guard rail of the Glass-Steagall act was still there, would we have still had a meltdown? While I cannot prove something that didn’t occur, one only need to look at the last meltdown with the dot com bubble. That was also Fed induced with money flooding the market. With the Glass-Steagall act in place, the money was forced into another sector, and we still had a meltdown. One can say it was not as big of a meltdown as our current one. The problem there though is the argument is just a matter of proportion. We didn’t have the historic low interest rates in the last meltdown and we didn’t have government passing legislation saying, “Everyone should own dot com stocks”.

Now we could get into the consequences of our entire banking structure and the problems with fractional reserve banking, but that would require too long of a post, and it would probably take me into deeper waters than I’m prepared to swim. The point of this post is to demonstrate that the anti-free market crowd doesn’t seem to understand causation. You can’t hold the free market accountable for something it did not create. Removal of the Glass-Steagall act was not the cause, just like removal of a guard rail doesn’t cause the driver to hit the tree. It both cases, it is outside influences, and in our current meltdown causation lies with the government.

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The Federal Reserve is not the government.

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