Repealing Glass Steagall Didn’t Cause the Crisis

Barry Ritholtz makes a very good point about the claims that repealing Glass-Steagall Act did not cause the financial crisis. Glass-Steagall was the Depression-era law that separated investment banking from commercial banking. (We can see the effects today as to comply with the law, Morgan Stanley was the investment bank spun-off from JP Morgan.)

The claim that the repeal did not cause the crisis is formally correct; however, it misses the point. When the crisis came, the absence of Glass-Steagall made the crisis much, much worse.

This is somewhat like people saying that the Titanic didn’t sink due to too few lifeboats. That’s true, but it obscures the issue. The Titanic did sink and the lack of lifeboats caused the deaths of hundreds, and it was entirely avoidable.

I don’t claim to know a good way of avoiding future credit crises. The nearest thing I have to a coherent opinion is to realize that these events happen and regulation is often a step behind. Therefore, we ought to avoid the temptation of trying to make a system that’s impossible to break, but instead make one that’s easy to fix. That’s why I lean towards favoring “big dumb rules” like breaking up large banks, instead of smart, smaller rules like the Volcker Rule.

Think of a speed limit on a highway. It’s a good example of a big, dumb rule that governs a complex system (traffic). The speed limit applies to everyone and is easily understood. The problem on the highways isn’t specifically the speed of drivers, but how careful they are. The reason why speed limits work is that by limiting speed, drivers are more careful. It’s not perfect, but it works well enough.

Posted by on July 31st, 2012 at 10:15 am

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