“We need radical change,” Lord Turner, chairman of England’s Financial Services Authority, said recently.  “And parts of the financial services industries need to reflect deeply on their role in the economy, and to recommit to a focus on their essential social and economic functions, if they are to regain public trust.”  The British are engaged in an active debate on how to make sure Too Big To Fail bailouts never happen again, and that they do away with corporate-state capitalism in which profits are privatized while losses are socialized.  In a capitalist system, the uncompromising hand of the market punishes bad decisions.

Lord Turner supports a plan to redesign the regulatory framework and revise the way the markets are supervised.

The Glass-Steagall Act, passed by the U.S. Congress in 1933, separated commercial banks (deposits and loans) from investment firms (trading and underwriting stocks).  The socially useful functions consequently do not interact with, and cannot be infected by, the gambling that modern banks seem unable to resist.  Congress and the Clinton administration repealed Glass-Steagall in 1999, and the banking system exploded nine years later.

Mervyn King, governor of the Bank of England, supports a Glass-Steagall-like separation of banks into “utilities” and “casinos.”  He would also shrink the size of the banks until they are small enough that we can let them fail.

The approaches favored by Lord Turner and Mervyn King are different, but both sides agree that something must be done now and that it is not enough to address the symptoms.  Any solution requires uncovering the underlying causes and preventing them from happening again.  The vigorous debate the British are having is, for the most part, not occurring in the United States.  Our leaders seem largely satisfied with the status quo—let the big dogs eat.  Over a year after the September 2008 collapse, no law has been changed, and the players behave as they did before.  The Obama administration’s “reform” proposals largely consist of reshuffling regulatory authority among the agencies that failed to protect the public last time.  The banks, unimpressed by the proposed “reforms,” have returned to business as usual.  Lord Turner warned last month, “we must not forget what occurred last autumn.  This was the worst crisis for 70 years—indeed potentially it could have been the worst in the history of market capitalism.”

The Obama administration, while propping up Wall Street with $23 trillion in cash and commitments, used to say, “We are saving Wall Street so we can save Main Street.”  Well, Wall Street is doing very well, thank you.  The New York Times headlined on October 17, “Big Players Find Clear Field To Take Risks.”  Two Wall Street giants, Goldman Sachs and JPMorgan Chase, posted record-breaking earnings of over three billion dollars in the third quarter.  Just over a year ago, at the height of the financial crisis, Goldman Sachs and Morgan Stanley became bank holding companies so, if necessary, they can borrow from the Fed.  The Federal Deposit Insurance Corporation (FDIC) has guaranteed $28 billion of Goldman bonds, which, according to the Wall Street Journal, will save Goldman $754 million in interest over the life of the bonds.  The record earnings, only a year after we were told the banks were on the brink, will produce huge bonuses.  Goldman Sachs, so far this year, has set aside $16 billion for bonuses—a sum that is expected to grow to $23 billion by the end of 2009.

Do the workers in our financial sector show many signs of Lord Turner’s “need to reflect deeply”?  Not so much.  Goldman understands the bonuses upset the public.  “We’re aware of what’s going on in the world,” said Goldman CFO David Viniar, “but we have to trade that off with treating our people fairly.”  The 30,000 Goldman Sachs employees will earn an average of $765,000 in 2009.  The country, helped by Wall Street, has developed a super-rich upper class.  The top 0.1 percent of taxpayers, about 141,000 in 2007, paid tax on an average income of $7.4 million.

Main Street, and the rest of the other 99.9 percent of the population, are not doing so well.  The Obama administration has declared that what it calls the “recession” is over because of a 3.2 percent rise in GDP—later revised down to 2.8 percent—which was driven largely by a federal stimulus.  The administration’s declaration, however, has had little resonance in the country.  The financial crisis struck an economy which had already been hollowed out by 20 years of globalism.  Wages are the lowest in 29 years.  About 23 percent (10.7 million) of U.S. homeowners owe more on their mortgages than their properties are worth.  The October 2009 unemployment rate, topping 10 percent for the first time since 1983, was 10.2 percent.  Getting laid off is a disaster not only for workers but for those who rely on them.  October was the 22nd straight month of job losses—the longest run since the Great Depression.  The same week that Goldman and JPMorgan announced their near-record earnings, 514,000 Americans filed for unemployment.  One of every five families has a member who is unemployed.  The official rate only counts those who have looked for a job in the last four weeks.  The broad unemployment rate is 17.5 percent—counting the unemployed and underemployed—which is approaching the 25-percent levels we experienced in the Great Depression.  The long-term unemployment rate—those unemployed for more than six months—is 36 percent of those unemployed.  The Fed predicts the unemployment rate will stay around ten percent at least through 2010 and remain high after that.  Approximately 7.6 million workers have been laid off over the past two years, and since we need 100,000 new jobs each month to keep up with population growth, we are now, according to Christina Romer, chairman of the White House Council of Economic Advisers, about 10 million jobs short.  No one can see where they will come from.

Neil Barofsky, special inspector general for the Treasury’s Troubled Asset Relief Program (TARP) was asked by CNN on October 21 what changes had been made to prevent a repeat of the September 2008 collapse:

I think, actually, what’s changed is in the other direction.

These banks that were too big to fail are now bigger.  Government has sponsored and supported several mergers that made them larger.  And that guarantee—that implicit guarantee of moral hazard, the idea that the government is not going to let these—these banks fail, which was implicit a year ago, it’s now explicit.

So if anything, not only has there not been any meaningful regulatory reform to make it less likely, in a lot of ways, the governments have made such problems more likely. . . . Potentially, we could be in more danger now than we were a year ago.

Barofsky’s concerns echo those of Depression-era senators who opposed centralizing the nation’s credit into a handful of large banks.  Congress, in enacting Glass-Steagall in 1933, made two basic decisions: first, that banking functions should be separated from investment functions; and second, that banking institutions should not be encouraged to grow.  Sen. Carter Glass (D-VA), the former Treasury secretary and architect of the Fed, wanted not only to separate the functions but to encourage growth.  He explained that diversity of resources would reduce risks:

Senators know that we have in this country hundreds of 1-crop banks, so to speak.  The diversity of their business is inappreciable; and if that one crop fails, the bank fails.  That would not actually apply to a branch-banking system.  A large bank in the cotton territory would be very much more apt to have a diversity of business than a weak bank in a small community of that territory; so that when the cotton crop fails in the far south, or the tobacco crop in Virginia, the Carolinas, Tennessee, and Kentucky fails, it does not necessarily follow that the bank in the larger community, with larger resources, would fail, as so often now occurs with the small banks in small communities.

Two fundamental causes are at the root of the small bank failures—lack of diversity and necessarily lack of earning power.

Congress, however, would not go along with Glass on encouraging bigger banks.  Sen. Peter Norbeck (R-SD), chairman of the Senate Banking and Commerce Committee, feared the change would lead to giant national banks with satellite offices throughout the country.  Power, he said, would “soon fall into very few hands, fall into central control.”  The country was feeling the widespread effects of small-bank failures.  Would the impact not be stronger when a much larger bank toppled?  Norbeck noted that

It is in the interest of the United States that a banking monopoly should not be created.  The theory of siphoning credits through a branch banking system has been exploded.  Theoretically, it functions perfectly, until under pressure the pipe springs a leak.  When a unit bank closes, there is merely a pop; when a system of branch banks closes, it is a detonation.

Congress agreed with Norbeck.  Everyone understood, of course, that National City would remain a big bank, but it would not be Too Big To Fail.  Since the functions were separated, there was less reason for it to fail.  The country prospered under the Glass-Steagall strategy.

Under the Clinton administration, Congress reversed both parts of the original plan.  First, in 1994 it passed the Riegle-Neal Interstate Banking and Branching Efficiency Act, which permitted national banks to acquire banks anywhere in the United States.  Now, as Senator Norbeck warned in 1932, a bank failure would be a “detonation.”  Second, in 1999, it repealed Glass-Steagall’s separation of banking from gambling functions.  The country was now as vulnerable as it had been in 1929.  And then the financial crisis came.

Has the financial sector grown far beyond what can be justified by its social benefit?  Without doubt.  Since the repeal of Glass-Steagall, the banks have become gambling casinos.  Today, the biggest gamblers operate with government guarantees.  They will keep any winnings, but the taxpayer will pick up all the losses.

On October 20, Mervyn King noted in Edinburgh, “The massive support extended to the banking sector around the world, while necessary to avert economic disaster, has created possibly the biggest moral hazard in history.”  King recommends splitting the banks up and separating utility functions from “casinos”—exactly what Glass-Steagall did.  Paul Volcker, who believes the banks should return to Glass-Steagall, has been ostracized by the Obama administration.  The administration discourages dissenters.  The world was less exciting under Glass-Steagall, but we never had a financial crisis.

Ben Bernanke, on October 23, was asked by the deputy governor of the Bank of England if he agreed with King that “casino” activities should be split off and bank size reduced until they are small enough that we can let them fail.  Bernanke replied that he would prefer “a more subtle approach without losing the economic benefit of multifunctional international firms.”  In other words, the big banks need to stay big to compete globally—again, let the big dogs eat.  Daniel K. Tarullo, an appointee of President Obama, called breaking up the banks “more a provocative idea than a proposal.”  Edward L. Yingling, president of the American Bankers Association, added that “you don’t want to create a system that raises great uncertainty and changes what institutions, risk management executives and lawyers are used to.”  We certainly wouldn’t want to do that.

“Why were banks willing to take risks that proved so damaging both to themselves and the rest of the economy?” asks King, before providing the answer:

one of the key reasons—mentioned by market participants in conversations before the crisis hit—is that the incentives to manage risk and to increase leverage were distorted by the implicit support or guarantee provided by government to creditors of banks that were seen as “too important to fail.”

The big banks could raise money more cheaply because of the de facto government guarantee.  They had less incentive, as King puts it, to “guard against tail risk.”  The “banks and their creditors knew that if they were sufficiently important to the economy or the rest of the financial system, and things went wrong, the government would always stand behind them.  And they were right.”

The financial sector, according to Lord Turner, “has swollen beyond its socially useful size and seems to make excessively large profits.”  In the United States, from 1929 to 1988, financial-industry profits averaged 1.2 percent of GDP—and never went above 1.7 percent.  In the 1990’s, the figure started to shoot up, reaching a peak of 3.3 percent in 2005.  It has now dropped but is still higher than it ever was before 1990.  The industry, as it has swollen, has also become more concentrated.  Henry Kaufman, in his new book, The Road to Financial Reformation, reports that our ten largest financial institutions today hold 60 percent of total financial assets, while in 1990 they held 10 percent, and our twenty largest hold 70 percent, up from just 12 percent in 1990.

When Goldman Sachs reports it won $100 million per day, that means another gambler lost $100 million.  There is no net gain to the sector and, of course, none to the society.  We must wonder what value someone who trades huge sums on miniscule changes in price adds to the economy.  For example, one trader at a Citigroup oil-trading subsidiary earned $100 million for such trades.  President Obama’s Pay Czar objected to Citigroup paying what they owed, so Citigroup—caught between a legal obligation and the Pay Czar—punted.  It sold off its profitable subsidiary.

The Too Big To Fail model encourages banks to gamble with vast sums of money to make enormous profits, with no fear for what will happen if the trades go bad.  The government guarantees also support the banks’ derivative dealers’ business.  The five biggest banks hold 97 percent of the more than $200 trillion in notional derivatives held by U.S. banks.

Lord Turner believes the big banks should be required to provide “living wills”—detailed instructions on how their operations can be wound down without taxpayer liability in the event of insolvency.  The living will is supposed to ensure that losses will be imposed on investors and creditors, not taxpayers.  “Now we may have to demand clarity of legal structure,” he adds.  Also, as King said, “It is hard to see how the existence of institutions that are ‘too important to fail’ is consistent with their being in the private sector.”  The line between public and private cannot be safely blurred, as the disastrous failures of Fannie Mae and Freddie Mac should have taught us.

Our government’s Too Big To Fail obligation goes on and on.  Citibank, for example, was bust in the early 1980’s because of improvident loans to less-developed countries so they could buy overpriced Arab oil.  The Fed weakened capital and accounting requirements, allowing the busted bank to float along—exactly what is being done now.  And Citibank has been saved several times since then.  Next came Larry Summers’ first bank bailout.  In 1994, Mexico was bust with huge loans outstanding to the American banks.  Congress refused to appropriate money for Mexico, so the Clinton administration, led by Treasury Secretary Robert Rubin and his deputy, Summers, raided an emergency Treasury fund created by FDR to protect the value of the dollar.  The Treasury paid Mexico, and Mexico paid Citigroup and the other banks.  The bank’s risk-taking escalates with each bailout.  Citigroup is now 34 percent owned by the taxpayers.

There are two solutions to Too Big To Fail.  One will work, and one will not.  The workable solution is to shrink the banks until, as King recommends, they are small enough that we can let them fail.  He notes that “The sheer creative imagination of the financial sector to think up new ways of taking risk will in the end, I believe, force us to confront the ‘too important to fail’ question.”  The nonworkable solution is that proposed by the Obama administration and Barney Frank: higher capital requirements and more regulation.  In other words, more of what has already failed miserably.  The problem is that our government doesn’t control the banks; the banks control our government.  The pro-bank policies of the Bush and Obama administrations have been seamless—the same people and the same policies.  Under existing law, our banks are the most heavily regulated industry in the world.  But the rules haven’t been enforced, and new ones won’t be either.

Some Democrats argued that their party’s proposed “reforms” were simply reauthorizing a system of “perpetual bailouts.”  Barney Frank and the Obama administration answered by drafting a provision borrowed from the environmental Superfund’s polluter-pays approach.  That, they said, would ensure that future losses would be paid by the banks, by making the big banks pay into a fund up front to cover any future failures.  But the banks objected, and the provision has been changed to solicit contributions after the event.  Anyone who thinks that provision will protect the taxpayers from another Too Big To Fail bailout is a potential customer for a bridge between Manhattan and Brooklyn.

Bernie Madoff single-handedly destroyed the theory that government can regulate even the most blatant crook.  King notes, “The belief that appropriate regulation can ensure that speculative activities do not result in failures is a delusion.”  In A Demon of Our Own Design (2007), Richard Bookstaber, a hedge-fund veteran, explains why additional regulations will not work.  “Trying to regulate a market entangled by complexity can lead to unintended consequences, compounding crises rather than extinguishing them because the safeguards add more complexity, which in turn feeds more failure.”  The regulators cannot keep up with the financial-product innovations—as we saw with derivatives.

Obama and his advisors don’t have—or won’t offer us—a theory of what exactly went wrong.  They list a number of possible contributing factors: subprime mortgages leading to the housing bubble; the Fed’s easy-money policy of making money available for good and bad projects; the reverse incentives created by securitization; incorporation of the investment-banking partnerships; slackness in the credit-rating agencies; huge bonuses that rewarded risk-taking; slack regulation by the SEC and bank regulators; and the unregulated market in the exotic and poorly understood derivatives.  They all may have had something to do with it, but listing them doesn’t explain how they triggered a collapse of the credit market.

In the Great Depression, Congress established the Pecora Commission, whose job was to examine banking practices, call CEOs to testify, and study data to determine the precise cause of the 1929 crash.  The commission, after a year of investigation, released a comprehensive report that confirmed what Senator Glass already knew: “Undoubtedly, . . . one large part [of the Depression’s causes] is that we do not require the separation of investment banking from commercial banking.”  Today’s government, by contrast, has showered trillions on the banks without any curiosity about what caused the trouble.

The Bush-Obama version of a cure could be worse than the disease.  They have piled up a perpetual debt—a debt so big that future generations, who had nothing to do with building it, can never pay it.

Can you cure a disease without knowing the cause?  Well actually, yes, but at a minimum, you have to change your behavior.

If Glass-Steagall had not been repealed, the collapse could not have happened.  Glass-Steagall intended “to provide for the safer and more effective use of the assets of banks, to regulate interbank control, to prevent the undue diversion of funds into speculative operations, and for other purposes.”  Section 16 of Glass-Steagall provided “nothing herein contained shall authorize the purchase by a national bank for its own account of any shares of stock of any corporation.”  Section 21 stated it “shall be unlawful for any person or firm issuing, underwriting, selling, or distributing stocks, bonds, debentures, notes, or other securities to engage at the same time to any extent whatever in the business of deposit banking.”  Mervyn King notes, “There are those who claim that such proposals are impractical.  It is hard to see why.”

As the story of the financial crisis unfolded, Wall Street’s behavior seemed characterized by grotesque risk-taking, which seemed very hard to understand.  But because the banks were playing with a government guarantee, their behavior was perfectly reasonable.