Glass Steagall: Is Breaking Up So Hard To Do?

10,000.

That’s where the Dow Jones Industrial Average has been hovering for the past two weeks. Since surpassing 10,000 for the first time in over a year on October 14, America’s most watched indicator of market health has been flirting with 10,000, moving above and below that level but never straying far from it.

So what’s keeping the Dow from resuming its meteoric rise from the depths of the Great Recession, when it collapsed below 6,500 just seven months ago? Why is it suddenly pausing after soaring over 50% in less than a year?

Mervyn King believes that he knows the answers to those questions. In fact, he believes that the primary answer is embedded in a strategy that was first implemented 75 years ago.

Mervyn? Who’s Mervyn?

Mervyn King, of course, is the Governor of the Bank of England (BoE), which makes him the British equivalent of Ben Bernanke, Chairman of America’s Federal Reserve Bank. Mervyn, though, might prefer to describe the Fed as the American equivalent of the BoE, given that it was first established in the 1600s and actually served as a model for the Fed’s creation.

So why rely on a British central banker for advice about the American financial system? Well, as compared to the immense economic pain felt by Americans after the collapse of its banking system, the British have experienced even worse suffering. In fact, just last week, the British government revealed that its economy is continuing to contract even though the economies of the United States, China, and the Euro Zone have begun to heal.

Unfortunately, the British economy has been far more reliant on the financial services industry than the economies of most other industrialized nations. Although a soaring banking sector transformed the stodgy British Isles into Cool Britannia for several decades, its recent collapse has generated a level of economic malaise that reflects and amplifies the contemporary American experience.

The World According to King

Thus, the advice of Britain’s central banker may indeed be worth considering for insight into the challenge of jump starting America’s economy as well. After all, America itself is a child of the British Empire, and shares a special relationship with its ancestral parent that spans centuries of economic development.

King’s primary recommendation, though, might strike American economists as an oddly “retro” prescription. Namely, he believes that banks that are “too big to fail” should be broken into independent pieces, with low risk commercial banking functions segregated from high risk investment banking activities.

In other words, Mervyn wants to return us to the days of Glass Steagall, an American law that was enacted during the darkest days of the Great Depression. Its primary purpose was to mandate the very segregation that King is now espousing, even though it was overturned a decade ago as a quaint relic of ancient economic history.

Toasters vs. Supermarkets

Even today, the assumptions that supported Glass Steagall seem quite reasonable. Namely, Americans had a right to expect that their low risk savings and checking accounts were safe, even though their commercial banks might act rashly and go bankrupt. The federal government guaranteed the safety of these accounts, up to a reasonable limit, and was prepared to assume control of any bank whose survival became doubtful.

However, Americans had no right to expect the federal government to bail them out if they deposited their funds in other investment vehicles. Thus, investment banking organizations were allowed to fail, and citizens who invested in them were expected to deal with the consequences of their own financial choices.

Under Glass Steagall, commercial banks were thus restricted to a world of limited risk and limited returns, where the most daring growth strategy involved offers of free toasters as gifts for opening checking accounts. But these restrictions collided with Citibank’s vision of becoming a financial supermarket; the Republican Congress and the Democratic Clinton administration thus decided to abolish Glass Steagall in 1999. Around this time, Citigroup acquired the insurer Traveler’s, and the race to create global banking organizations was on.

Can It Be Done?

To be sure, many now argue that any new government restrictions on the financial services industry would do far more harm than good during this period of nascent recovery. They assert that such restrictions would impede banking institutions in their efforts to raise new capital, hire new talent, and pursue new business opportunities in their quests to repair their balance sheets.

Furthermore, even those who agree with King are silent on how the government would actually manage any banking breakups. Many believe that Citigroup, for instance, is simply too complex an institution to be dismantled quickly. And others accurately note that our federal government has been encouraging the development of new financial supermarkets through such mergers as the Bank of America and Merrill Lynch.

Nevertheless, as the Dow slows to a halt at 10,000, and as economists warn that future economic growth will be nothing like what we usually expect during times of economic recovery, it is reasonable to wonder whether a more drastic approach to government regulation is required. That is precisely the position taken by Mervyn King; only time will tell whether he is proven right or wrong.