Axel Leijonhufvud vs. Calomiris and Haber

Leijonhufvud writes,

The financial structure inherited from the 1930s divided the system into a number of distinct industries: commercial banks, savings and loan associations (S&Ls), credit unions, and others. It also divided it spatially. Banks located in one state could not branch across the line into another. This structure of the financial sector gave it great resilience. On another occasion I used the metaphor of a ship with numerous watertight compartments. If one compartment is breached and flooded, it will not sink the entire vessel.

This is directly the opposite of what Calomiris and Haber argue. They say that American cultural hostility to large banks produced an overly fragmented system, and that this fragmentation is the root cause of the peculiar instability of American finance.

Leijonhufvud elaborates,

At the time, the abolishment of all the regulations that prevented the different segments of the industry from entering into one another’s traditional markets was seen as having two obvious advantages. On the one hand, it would increase competition and, on the other, it would offer financial firms new opportunities to diversify risk. Economists in general failed to understand the sound rationale of Glass-Steagall. The crisis has given us much to be modest about.

In other words, economists championed open competition without thinking about how this would turn idiosyncratic risk into systemic risk.

The thing is, I was following these regulatory issues at the time, and I do not think that economists were as influential as we would like to believe. I think that the driving factors were computer technology, inflation, and massive lobbying. With high inflation, the regulatory ceilings on deposit interest rates that were a vital part of the regulatory structure became untenable. Moreover, with computer technology, it became easy for Wall Street to “disintermediate” banks using money market funds and securitization. These forces produced an inevitable turf battle between commercial banks and investment banks, which took years to resolve, as everybody lawyered up on the lobbying front. There were multiple possible political/regulatory outcomes, but hanging on to Glass-Steagall was not one of them.

Another Leijonhufvud quote:

Deregulation. . .allowed the great investment banks to incorporate and one by one they all did so. . .Incorporation meant limited liability for the investment bank and no direct liability for its executives. The incentives for executives in the industry changed accordingly. . .Now they are seen as jet-setting high rollers. Economists in general failed to predict this change in bankers’ risk attitudes. We have much to be modest about.

I cannot disagree with that.

However, I would instead put most of the emphasis on the regulations that directly affected housing finance. The pressure to lend with little or no money down and the designation of highly-rated mortgage securities as low risk for bank capital purposes are the main villains in the story as I tell it.

3 thoughts on “Axel Leijonhufvud vs. Calomiris and Haber

  1. Working with the Titanic analogy, you want bulkheads separating the flooding, but you want the bailing pumps to be interconnected.

  2. Arnold:

    You said, “…and I do not think that economists were as influential as we would like to believe.”

    There was one very influential economist who did advocate for repeal of Glass-Steagall when it was being considered by Congress – Alan Greenspan. I am generally a Greenspan admirer (which probably doesn’t endear me to most folks here). But I recall him testifying before Congress in support of Gramm-Leach-Bliley Act (GLBA – Glass-Steagall repeal) in 1999 and I thought then that it would be a grave and serious mistake. I still think it was a grave mistake, and that it should be reversed.

    I can’t and wouldn’t argue that had GLBA not been passed (Glass-Steagall separations been retained), that neither the housing bubble nor the financial crisis would have occurred. Far too many counterfactuals required to make that claim, and even I don’t believe it myself.

    But I can and do argue that, whatever “bubble” and resulting financial crisis might have occurred, it would have been contained largely within the investment banking sector and had far fewer detrimental effects on the overall economy – the housing sector especially – by leaving the commercial banking sector largely unaffected.

    When Greenspan testified before the Congress on GLBA, his reasoning was that by “combining” the commercial and investment banking functions, the inherent conservatism (and more rigorous Fed regulatory structure) of commercial banking would positively influence – add a measure of conservatism to – investment banking. He effectively testified to that before Congress. Then, in the aftermath of the financial crisis, he apologized for overestimating that effect, and underestimating the degree in which notable firms engaged in more risky rather than less risky practices as a result of GLBA.

    The net effect of GLBA, rather than encouraging investment bank practices to become more conservative, encouraged investment banking arms of some firms to engage in more risky practices due to implied Fed (and FDIC) support of commercial parent firms – or even the possibility of commercial bank buyouts of non-integrated investment banks. In short, all GLBA did was provide investment banks and banking access to the Fed window, Fed support, FDIC support, etc. Something they had never enjoyed under Glass-Steagall. And all the while, NOT suffering from any of the regulatory or control structures of the Fed, FDIC, etc. – investment banks, and investment banking operations of integrated banks, continued to fall under SEC regulatory frameworks.

    Glass-Steagall intentionally blocked the path of access to the Fed, the FDIC, and ultimately to Treasury for investment banking operations, limiting risk contagion. GLBA removed the blockage to that path, and enhanced risk contagion.

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