Introducing the ‘ 21st century Glass-Steagall Act’ not an option, but a necessity

Chitro Majumdar, Chief founder, RsRL, Luxembourg

By Chitro Majumdar, Chief founder, RsRL, Luxembourg

June 30, 2020

Strap: There is no actual solution that is painless. Covid-19 has exposed the vulnerability of the current mechanism and has led the beginning of what seems to be inevitable and imminent – ‘‘The Great Depression of the 21st century’

Statements such as “Wall Street will need a bail out” and the “Great depression of the century is here” have started surfacing. Clearly, the strategy of flooding the global markets through back to back fiscal stimuli has been not very effective. The outbreak of pandemic Covid-19 has merely exposed the risks of this strategy and probably has led the beginning of what seems inevitable and imminent – ‘The Great Depression of the 21st century’ and it’s too late to fix it now.

Over the years, the extra liquidity pumped in the system through easing has disproportionately found its way into financial markets leading to sustained period of asset over-valuations and the economic growth has not been as proportionate. For instance US GDP from 2000-2010 grew by 41% but DJIA Index gained only 5% the period, from 2010-2020, US GDP grew 46% and DJIA index gained 200% (before it started correcting). Market Capitalization to GDP, also known as ‘Buffet Indicator’ is close at 40 year high but so is its Debt to GDP with Gross National debt at $23.5 trillion and exceeds the GDP. Estimated deficits before the outburst of pandemic were $1 trillion but could rise rapidly as the states tries to fight the crisis. Central Bank’s scope too appears limited. Fed Debt to GDP is estimated to touch 120%, highest since World War II. In March, Fed’s balance sheet crossed $5 trillion for the first time and is expected to touch $7 trillion by June 2020, taking the Fed’s balance sheet to 10 times from its lows.  At this rate, America could probably be going the Greek way. This is a multiple nightmare situation. But before it’s too late, we need more structural, more fundamental strategy which could jump start an era of 50 years of prosperity at the cost of short term pain which is inevitable.

Restoring ’Glass-Steagall Act’

Tough times call for tough measures. The path-breaking Glass-Steagall Act, which was introduced in 1933 post the Great Depression need to be brought back. After being repealed in 1999 as a part of Financial Services Modernization Act by Bill Clinton, the global financial markets have seen extreme rise in volatilities and major economic collapses of unparalleled size and scale, the first being the sub-prime crisis and the second we could be undergoing now. Many argue that the act could not have prevented the 2008 financial crisis, as it were not the banks but the investment banks such as Lehman Brothers that were the culprits. After that crisis Central Banks and regulators world over put restrictions on certain risky and complicated financial and derivative products to ensure of no such disaster in the future. But that has not stopped bank funds finding the way to the financial markets whether it is through massive buybacks or any other routes. The ongoing meltdown proves how vulnerable the global financial markets are to the Black Swan events. It only makes the case of bringing back the Glass- Steagall Act stronger

So what is Glass-Steagall Act?

Passed in 1933, Glass Steagall Act, was introduced after the Fed failed to prevent the speculative bubble that preceded the great depression – since 1922 until the peak in 1929, stock market had given an average of 20% every year, finally leading to a collapse. This was fuelled by large chunk of bank funds going into stock speculation. The Act prohibited banks of investing in risky securities except government bonds an end to the dangerous bank practices restricting depositor’s money into risky financial products such as equity and other derivatives. Banks had to choose whether they wanted to be a commercial bank or an investment bank. In the process thousands of banks that could not cope were allowed to fail. But it redirected the entire system’s capital from the speculative stock markets to capacity building.

Today the world finds itself in a similar situation and a similar solution is the need of the hour.

A recent study by David Singer, an MIT professor along with his colleague Mark Copelovitch, political scientist at University of Wisconsin supports this theory. Together they have spent years on studying various data and have come to a conclusion –“Empirically, systemic bank failures are more likely when substantial capital inflows meet a financial system with well-developed stock markets. Banks take on more risks in these environments, which make them more prone to collapse.” Singer and Copelovitch examined what makes banks vulnerable under contemporary conditions. They looked at economic and banking-sector data from 1976-2011, for the 32 countries in the Organization for Economic Cooperation and Development (OECD). That time period begins soon after the Bretton Woods system of international monetary-policy cooperation vanished, which led to a significant increase in foreign capital movement. From 1990 to 2005 alone, international capital flow increased from $1 trillion to $12 trillion annually.

After the banking crisis in 2008, the spirit of the Glass-Steagall Act was partially restored through Volcker Rule, which limited use of customer deposits for speculative activity. Glass-Steagall could be re-written to adapt with the current situation to make it a ‘21st century Glass-Steagall Act.’

But restoring this could come at a cost. Many banks will have to be sacrificed and not bailed out, a decision which may not be easy to take. The speculative units should bear the consequences of their greed. The world will have to undergo a recessionary phase before but there will be atleast light at the end of the tunnel. Whether the decision makers are able to take the bold steps and guide us through needs to be seen.

MAJUMDAR is Chief Strategic Advisors of Sovereign Institutions and Chief founder at RsRL; MAJUMDAR has developed models for Post COVID-19 pandemics and Climate Risk & CATastrophe Risk Tools Email: chitro.majumdar@rsquarerisklab.com