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Clinton vs. Eichengreen on the origins of the crisis

- September 24, 2008

Over at “the other place where I blog”:http://crookedtimber.org/2008/09/23/clinton-on-the-bail-out/ I write about a meeting that I and a few other bloggers had with Bill Clinton. Most of this isn’t of direct political science interest (except in the broad sense that politics is interesting to political science). But there was one bit of the conversation where a political scientist has something of interest to say. Throughout the conversation, Clinton was at pains to defend his role in signing the bill replacing Glass-Steagal. He suggested that this hadn’t had the negative consequences that some say it had, and may have had positive consequences, but allowed that there might be convincing arguments to the contrary out there that he would like to hear about. Perhaps one such argument comes from political scientist/economist “Barry Eichengreen”:http://www.voxeu.org/index.php?q=node/1684. Eichengreen argues that:

At the domestic level, the key decisions in the United States were to deregulate commissions for stock trading in the 1970s and then to eliminate the Glass-Steagall restrictions on mixing commercial and investment banking in the 1990s. In the days of fixed commissions, investment banks could make a comfortable living booking stock trades for their customers. Deregulation meant greater competition, entry by low-cost brokers like Charles Schwab, and thinner margins. The elimination of Glass-Steagall then allowed commercial banks to encroach on the investment banks’ other traditional preserves. (It was not only commercial banks of course, but also insurance companies like AIG that did the encroaching.)

In response, investment banks to survive were forced to branch into new lines of business like originating and distributing complex derivative securities. They were forced to use more leverage, funding themselves through the money market, to sustain their profitability. Thereby arose the first set of causes of the crisis: the originate-and-distribute model of securitisation and the extensive use of leverage.

It is important to note that these were unintended consequences of basically sensible policy decisions. … eliminating Glass-Steagall was a fundamentally sensible choice. Conglomeratisation allows financial institutions to better diversify their business. Combining with commercial banking allows investment banks to fund their operations using a relatively stable base of deposits rather than relying on fickle money markets. This model has proven its viability in Germany and other European countries over a period of centuries. These advantages are evident in the United States even now, with Bank of America’s purchase of Merrill Lynch, which is one small step helping to staunch the bleeding.

Again, however, the problem was that other policies were not adapted to the new environment. Conglomeratisation takes time. In the short run, Merrill, like the other investment banks, was allowed to lever up its bets. It remained outside the purview of the regulators. As a self-standing entity, it was then vulnerable to inevitable swings in housing and securities markets. A crisis sufficient to threaten the entire financial system was required to precipitate the inevitable conglomeratisation.

I’ll pass this piece on to the Clinton people whom I met: in the obviously very unlikely eventuality that (a) he has a response, and (b) that I can publish it, I’ll put it up here.