How the Financial Crisis Happened

First of all, let me apologize for not contributing to these pages over the past month. I had to have a bit of surgery to correct a small problem with the arterial blood flow in my legs and it took a short while before I was ready to write again. But if you think that I'm going to let the current financial crisis pass by without comment, you don't know me very well.

Over the past weekend I finished rereading Barbara Tuchman's The March of Folly:From Troy to Vietnam. The thesis of this book is that, in the most crucial moments of the great crises of history, governments have made decisions that are directly contrary to that government's immediate and long-term best interests.[1]

According to Tuchman (pp. 3-6) a government's policy must meet three criteria to qualify as "folly:"

1. It must have been seen as counter-productive in its own time and not by hindsight.

2. A feasible alternative course of action must have been available at the time.

3. The adopted policy must have been the action of a group rather than an individual and its impact must have persisted beyond one political lifetime.

Let us now take a look at the current situation in consideration of Tuchman's definition of folly.

The current situation has its roots in the Glass-Steagall Act of 1933 which divided the banking industry into two separate categories: commercial banks and investment banks.[2]

A commercial bank is the everyday, run of the mill, street-corner bank where you deposit your money, have a savings account, and get a loan to pay for your new car. On the other hand an investment bank concerns itself with buying and selling federal, state, and municipal bonds; financing business expansion, and managing very large sums of money such as pension plans, IRAs, 401-k accounts and mutual funds.

Under Glass-Steagall, commercial banks were not allowed to deal in stocks or underwrite any form of securities other than government bonds. The commercial banks were limited to making loans to individuals and businesses in accordance with rules set by the Federal Reserve System. Practically all other financial business was left to the investment banks.

The system worked quite well until the middle 1980s, when the Reagan-inspired boom markets created large profits for the investment banks. In turn, the commercial banks began to lobby for a relaxation of the rules that prevented them from taking "a piece of the action" in the investment sector. In 1999, the commercial banks got their wish with the passage of the Gramm-Leach-Bliley Act.

Under the provisions of Gramm-Leach-Bliley, commercial and investment banks were allowed to consolidate into a single institution which had essentially free reign to offer everything from passbook savings accounts to speculative financial investments such as commodities trading and credit default swaps.

For 8 years the financial markets operated as if the Great Depression had never happened and that prosperity would reign forever. Regulation of the markets was either lax or non-existent. Then came the near-collapse of the housing mortgage sector and the resultant 80 billion dollar federal takeover of Fannie Mae and Freddie Mac.

By Tuchman's criteria, the Gramm-Leach-Bliley Act meets all the requirements to be taken as folly.

There were many voices raised in opposition to the bill, most of them from well-respected economists who warned that allowing the merger of banking functions would severely strain the existing regulatory structure and the ability of agencies such as the Securities and Exchange Commission as well as allow the new financial giants to "cook the books" in order to avoid taxation on their profits.

As to her second requirement, that a reasonable alternative have been available, it should have been obvious that the system was working and the proposed changes were directly related to the envy of commercial bankers at the profits being made by the investment banks. In light of those facts, the most reasonable course of action would have been to do nothing.

The fact that the fallout from the current near-collapse of the economic infrastructure meets Tuchman's last criteria: this mess is going to haunt us for probably the next decade.

I invite you, gentle reader, to join me in sending a few e-mails to our respective congressmen and congresswomen with a message so simple that even a politician can understand it:

"Get off of your influence-peddling ass and start doing what you were elected to do, which is look out for the interests of the American people!"

[1] Tuchman, Barbara. The March of Folly: From Troy to Vietnam. New York: Ballantine, 1984.

[2] Vestiges of the Glass-Steagall Act, as well as thelaterGramm-Leach-Bliley Act, are included in various chapters of Title 12, United States Code (12 USC).