Governments around the world have authorized $11 trillion in tax programs to mitigate the economic and social fallout from the COVID-19 pandemic. These programs will cause the sovereign debt burden to exceed 100% of global GDP by 2021, surpassing the record set during World War II. Central banks supported government spending and stabilized financial markets by buying $6 trillion in government bonds, corporate debt and other assets.
Governments and central banks essentially rehearsed their extraordinary responses to the 2007-09 global financial crisis, but at a faster pace and with an even broader scope. Central banks injected huge amounts of liquidity into financial markets to help borrowers and prevent failures of systemically important financial institutions. Central banks pushed interest rates to historic lows, encouraging investors to buy corporate bonds, stocks and other risky assets. By inflating the values of speculative investments, central banks have deepened deeply troubling inequalities of wealth and income between the wealthiest members of society and everyone else.
The global response to the pandemic confirms that we have not solved the problems that brought us to the Great Recession more than a decade ago. The world remains trapped in a “global catastrophic loop” in which governments and central banks must ensure the survival of “universe banks” (banks that operate in capital markets) and “shadow banks” (large financial institutions non-banks such as private equity firms). , hedge funds, insurance companies and mutual funds). Central banks must buy distressed financial assets to ensure financial market stability and prevent threats to the survival of financial giants. Meanwhile, the financial giants are securing rapidly rising debt levels for governments, businesses and households.
The global catastrophic loop has created a menacing overhang of public and private sector debt. Total global debt has increased by more than 50% between 2007 and 2020. The ratio of global debt to global GDP reached 331% in March 2020, an all-time high.
The accelerating rise in global debt over the past two decades has produced a vicious cycle of debt-fueled booms followed by painful recessions, each of which must be “contained” by government and central bank interventions. Each new intervention creates a greater sense of complacency among investors, thus fostering a bigger and even more threatening boom. Sooner or later, governments and central banks will not be able to “contain” the explosion after a boom, and another Great Depression may come.
To break the global catastrophic loop and restore financial stability, we need to pass a new Glass-Steagall Act. The original Glass-Steagall Act of 1933 supported stable financial markets and prevented systemic financial crises for more than three decades after World War II. Glass-Steagall separated banks from capital markets and prohibited non-banks from taking deposits. It established risk cushions that prevented financial disruptions in one sector of the financial markets from spreading to other sectors and triggering systemic crises. Regulators could respond to problems in one sector without having to bail out the entire financial system. Regulators could also encourage strong financial institutions in one sector to support struggling institutions in another sector. The weakening and repeal of the Glass-Steagall prudential buffers helped spark the subprime mortgage boom that led to the Great Recession.
A new Glass-Steagall Act would greatly improve financial stability. This would prevent banks from using state-protected deposits to fund speculative capital market transactions. It would prohibit banks from underwriting securities other than government bonds. This would prevent non-banks from offering short-term financial instruments (like money market mutual funds) that masquerade as “deposits” but are not covered by deposit insurance and other banking regulations.
A new Glass-Steagall Act would restore risk buffers and prevent contagion between financial sectors. It would improve market discipline by preventing banks from transferring their government subsidies to subsidiaries operating in the capital market. Regulators would no longer be forced to prop up securities markets due to concerns over massive securities exposures held by banks. Shadow banks would shrink considerably, as they could no longer finance their operations with short-term financial instruments. Banking regulators could more effectively monitor and control the levels of short-term claims in financial markets, as these claims would be issued only by banks.
A new Glass-Steagall Act would create a more diverse and competitive banking system by dismantling universal banks. Banks would return to their traditional role of providing deposit, credit, trust and payment services to businesses and consumers. Banks would have a much greater incentive to serve all segments of business and society, instead of focusing their efforts on Wall Street speculators, multinational corporations and the wealthy.
Securities markets would become real markets again because they would not be tied to the fortunes of universal banks and “too big to fail” shadow banks. Our political, regulatory and monetary policies would no longer be held hostage by financial giants. Banks and securities firms would regain their role as servants – not masters – of commerce, industry and society.
In 1914, Louis Brandeis warned the American public: “We must break the Money Trust or the Money Trust will break us. Congress followed his advice in 1933 by enacting the Glass-Steagall Act. Brandeis’ warning is just as timely today as it was in 1914 and 1933.
Arthur E. Wilmarth, Jr. is Emeritus Professor of Law at George Washington University in Washington, D.C. This editorial is based on his book, “Taming the Megabanks: Why We Need a New Glass-Steagall Act (Oxford University Press)” , which will be released on October 2.