In December I attended a remarkable conference, Money as a Democratic Medium, where a whole spectrum of progressive critiques of the current economic situation were discussed. I noticed, however, that many attendees did not seem to entirely grasp that our currently state of financial instability and financially-driven inequality was very much constructed by legislation from the 1980s on that revised the laws governing our financial infrastructure — and that these laws were passed due to aggressive lobbying by the financial interests that benefited from them. So my next series of posts will go into some detail on how the comprehensive regulatory regime that was so carefully designed in the 1930s was dismantled. (Note that Katharina Pistor is one of the few who has a good grasp of this problem, and these posts complement her work.)
This post opens the discussion with a background exposition of the US Depression era financial legislation and what it was designed to do.
In the 1930s and 40s a comprehensive regulatory regime was designed for the financial system. The designers of this system had learned from the real estate and the stock market booms and busts of the 1920s and were not just conscious of the credit-creation function of banking, but also of the disastrous consequences that result when bank credit is used to finance leveraged positions in financial or real assets. Thus, the system was designed with firewalls that would keep credit from flowing inefficiently from the banking system into sectors, like housing and stock market investments, where there was abundant empirical evidence that the primary result would be asset price inflation.
The new system also took into account the fact that state and common law had long granted a limited form of self-governance to the commodities and securities exchanges, which set rules for their members, and gained certain privileges in deference to the role they played in establishing the prices for financial contracts. In the new regime the Exchanges would be recognized as “Self Regulatory Organizations.” Every one of them was, however, made subject to the supervision of either the SEC or the Secretary of Agriculture (prior to the creation of the CFTC).
The financial regulatory laws enacted in the 1930s and early 1940s were designed to augment the existing legal regime governing financial contracts, which was constructed on the principle that financial contracts are legally enforceable only when they are tied to the real economy. Thus, if any one of three conditions are met (i) the contract insures one party against an existing risk, (ii) the intent is to deliver the underlying asset, or (iii) the contract is traded on a designated exchange, the contract is deemed to play a role in distributing real economic risk and is legally enforceable. On the other hand, a financial contract where both parties were speculating on some future event – such as the price of an asset – had to be traded on an exchange or it would be considered a wager and void.[1]
The financial regulatory laws enacted in the 1930s and early 1940s were designed as a comprehensive regulatory regime where every financial product had a designated regulator. The first step in this process had been the Federal Home Loan Bank Act of 1932 which established a Federal Home Loan Bank System to support liquidity in the mortgage markets on the model of the Federal Reserve System. Mortgage lending had never been a significant activity for commercial banks, but was instead the purview of a variety of savings associations. Very innovative policies would be put in place to support the mortgage markets over the course of the decade, but this history is not pertinent here.
The second step in the process of creating a comprehensive regime with firewalls designed to construct a silo’d financial system was to separate out banks from brokers and dealers on financial markets. Formal separation of the commercial banks from their investment banking affiliates was adopted in the Banking Act of 1933 (“the Glass-Steagall Act”).
The next step was to extend federal law to cover the broker-dealers, the exchanges, and over-the-counter markets. The latter were covered, not because major improprieties on OTC markets had been discovered in the years leading up to the Great Depression, but because legislators recognized that “since business tends to flow from regulated to unregulated markets … the regulation of exchange markets made necessary the regulation of [over the] counter markets” (SEC Tenth Annual Report, 1945: 44). That is, 1930s legislators were well aware of the need for a comprehensive regulatory regime. Thus, the Securities Act of 1933 (“’33 Act”), the Securities Exchange Act of 1934 (“’34 Act”), the Commodity Exchange Act of 1936 (“CEA”), and the Investment Company Act of 1940 (“’40 Act”) were designed to ensure that there was no unregulated financial market into which business could flow.
The Commodity Exchange Act of 1936 (CEA) prohibited trading of commodities contracts for future delivery – a category which encompasses options and swaps contracts that reference commodities — with two exceptions, contracts traded on designated markets and the forward contract exclusion (which requires that delivery is expected take place).[2] Observe that this prohibition was simply a means of bringing well-established state and common law rules under the purview of federal law.
The SEC regulated broker-dealers and their over-the-counter transactions through the creation of a new self-regulatory organization (explicitly authorized by the Maloney Act of 1938), the National Association of Securities Dealers (which was replaced in 2007 by FINRA, the Financial Industry Regulatory Authority). This decision to create an SRO for the purpose of regulating the formerly unregulated segments of the securities markets should have been viewed as precedent. Any unregulated financial market, needed to form a self-regulatory organization, and apply to the SEC (or the CFTC as might be appropriate) for its right to exist.
So how did we go from a system of comprehensive regulation in 1940 to the 2008 environment where vast swathes of the financial system were unregulated? The short answer is that the deregulatory ideology of the 1980s and 1990s turned a comprehensive regulatory regime into a tattered web of regulations and in doing so facilitated the growth of the same kind of conduct that the regulatory regime had been designed to repress in the first place.
Links [to be updated]
The dismantling of the economy’s legal infrastrucure II: Hedge and private equity funds
The dismantling of the economy’s legal infrastructure III: Derivatives
The dismantling of the economy’s legal infrastructure IV: Mortgage lending
The dismantling of the economy’s legal infrastructure V: Commercial and investment banking
[1] Notice that in a contract where both parties are speculating, neither party has a real economic risk that is being transferred; instead, the two parties are just making different predictions about the future. As a result, the frequent claim that speculation serves to transfer risk away from those who will have difficulty bearing is not applicable to those contracts that were treated as wagering contracts under 19th and early 20th century financial regulatory principles.
[2] Stein, “The Exchange-Trading Requirement of the Commodity Exchange Act,” 41 Vand. L. Rev 473, 480-81, 491 (1988). See also Lynn Stout, “Why the law hates speculators,” Duke Law Journal, 48(701), pp. 722 – 3.
Synthetic Assets 
I am going to make an unpopular statement in that while I don’t think the 1930s financial regulatory regime should have been dismantled willy nilly in the way it was in the 1980s and 1990s I also think in the fullness of history the 1930s regime was far more deeply flawed from the get go and put into place by some deeply problematic individuals such as Henry Steagall. In part these flaws I think in part led to it’s uncontrolled demise.
In many ways I think the too much of the reforms of the 1930s were attempting to preserve a idolized vision of the 1800s well into the 20th Century. If you compare the views on Banking of someone like Canadian Prime Minister Mackenzie King very much probably the most important international ally of FDR and New Deal America prior to World War II to that of Henry Steagall they were night and day diametrically opposed. Steagall wanted to use the power of the Federal govt through government backed deposit insurance to preserve the 18th century unit banking model. King on the other hand in the context of Canadian politics saw banking as something inherent federal and national and in cooperation with other nation building initiatives he would become famous for in Canadian political history such as the creation of what is now known as Air Canada and the Canadian Broadcasting Corporation.
King was essentially what I guess you could call a progressive Hamiltonian whereas Steagall was of the Jeffersonian/Jacksonian school with FDR straddling the middle. The thing I find interesting is that in this era of Black Lives Matters etc. you still have people like Arthur Wilmarth trying to defend and justify this legacy Jeffersonian/Jacksonianism in people like Henry Steagall when if you stripped away the pure partisan link of today’s political left and Democratic party to that of the of Henry Steagall I think instinctively most Americans would be far more inclined towards King’s progressive Hamiltonianism.
There are many thinks to dislike about Canada as country and Mackenzie King’s political legacy is not all without it’s problems(King like FDR interned Japanese Canadians, King like FDR also refused to allow Jewish Refugees into Canada in the 1930s, and by many accounts King had privately racist views towards non white Canadians) yet the thing I keep coming back to is Canada’s system actually works and has a long run history of actually working. Many of the alternatives so to speak being promoted by academic economists and law professors in Europe and the US are basically untried and even if you use the baseline of the success of the US’s 1930s New Deal model this model only lasted about 30 to 40 years before coming under stress. Canada’s model of banking is largely unchanged since World War I.