Anatomy of a Crisis

BERKELEY – Getting out of our current financial mess requires understanding how we got into it in the first place. The fundamental cause, according to the likes of John McCain, was greed and corruption on Wall Street. Though not one to deny the existence of such base motives, I would insist that the crisis has its roots in key policy decisions stretching back over decades. 

In the United States, there were two key decisions. The first, in the 1970’s, deregulated commissions paid to stockbrokers. The second, in the 1990’s, removed the Glass-Steagall Act’s restrictions on mixing commercial and investment banking. In the days of fixed commissions, investment banks could make a comfortable living booking stock trades. Deregulation meant competition and thinner margins. Elimination of Glass-Steagall then allowed commercial banks to encroach on the investment banks’ other traditional preserves.

In response, investment banks branched into new businesses like originating and distributing complex derivative securities. They borrowed money and put it to work to sustain their profitability. This gave rise to the first causes of the crisis: the originate-and-distribute model of securitization and the extensive use of leverage.

It is important to note that these were unintended consequences of basically sensible policy decisions. Other things being equal, deregulation allowed small investors to trade stocks more cheaply, which made them better off. But other things were not equal. In particular, the fact that investment banks, which were propelled into riskier activities by these policy changes, were entirely outside the regulatory net was a recipe for disaster.