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Home | Blog | Why Not Replace Dodd-Frank With Glass-Steagall?

Why Not Replace Dodd-Frank With Glass-Steagall?

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02/07/2017

Last week President Trump started moving forward with his campaign promise to repeal the disastrous Dodd-Frank Act, taking steps to walk back some of the rules and regulations the bill spawned. While these are promising first steps, the larger provisions of the bill will have to be met with legislative action.

For those not familiar with the Dodd-Frank Act, it was the Obama Administration’s response to the financial crisis that increased costs on consumers while further undermining the stability of the banking sector by making the “Too Big to Fail” banks bigger. America faces dangerous Bank consolidation due to the mountains of red tape Dodd-Frank has created for lenders, forcing many small and community banks to merge with larger financial institutions. Since Dodd-Frank has passed, only three banks have been chartered in the US.

Bank Consolidation.png

Another issue with the Dodd-Frank Act is the Volcker Rule. The goal of the Volcker Rule was to prevent banks from making risky speculative trading. The policy tried to replicate the separation between investment and commercial banking that was established by Glass-Steagall before it was repealed by Bill Clinton.

The problem with this approach however is that instead of establishing a firm firewall by dividing the financial institutions, regulators are required to look over bank activity and try to figure out what trades are “legitimate” and which ones are “speculative.” This isn’t always easy. Derivatives, for example, are often portrayed as insidious weapons of mass destruction, they can serve a great social function by hedging future risk when used appropriately.

Financial regulators have a poor track record as is without requiring them to be mind readers.

This is precisely why President Trump should follow through with his campaign platform, and offer Glass-Steagall as a replacement for Dodd-Frank.

While many would understandably scoff at the idea of replacing regulation with another regulation, a Glass-Steagall rule makes sense given the current state of the American banking industry.

As Murray Rothbard wrote:

Many free-market advocates wonder: why is it that I am a champion of free markets, privatization, and deregulation everywhere else, but not in the banking system? The answer should now be clear: Banking is not a legitimate industry, providing legitimate service, so long as it continues to be a system of fractional-reserve banking: that is, the fraudulent making of contracts that it is impossible to honor.

While the fractional-reserve banking Rothbard condemned would be limited in a free market, our banking system is anything but. The existence of the Federal Reserve, the FDIC, and other state-backed institutions undermine market discipline in lending and create moral hazard. The 2008 crisis was a perfect example of how bank CEO’s benefitted with massive bonuses during the housing bubble while taxpayers ended up bailing them out when their government-subsidized behavior went bust.

As Frank Shostak wrote when defending Glass-Steagall:

As long as we have a central bank, it makes sense to impose tighter controls on banks in order to minimize the damage the central bank's policies inflict. 

Reinstalling Glass-Steagall would not solve the underlying issues of mixing government and banks, but it would separate traditional commercial banking from the more complex and risky investment banking. While commercial banks could still lose money by undertaking a number of bad loans, this would prevent them from purely speculative trading.

Perhaps most importantly, combined with eliminating Dodd-Frank, this should lead to a resurgence in community bank charters and allow for a more dynamic banking system in the US. Considering community banks are vital for small business financing (who are often ignored by Wall Street), this would also be a major boost for economies not located in NYC, DC, or Silicon Valley.    

It’s also worth noting that this approach would be good politics.

After spending much of his campaign attacking the “financial elite”, Trump has chosen to surround himself with former Goldman Sachs traders to head the Treasury and his National Economic Council. In spite of how disastrous Dodd-Frank has already proven to be, any steps to “deregulate” Wall Street will be spun as “filling” rather than “draining the swamp” and will inevitably be blamed when we have our next financial crisis. By embracing Glass-Steagall, which was supported by Bernie Sanders and introduced in the house this year by Rep. Tulsi Gabbard, any such attack will be harder to make.  

The rare time where good policy is also good politics. 

Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.
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