Rebuild that banking wall

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A few years ago, an observer in a windowless boiler room in Zurich watched a horde of "gnomes of Zurich" — currency traders — responding to news clips racing across their computer screens, like air traffic controllers tracking blips on a screen and guiding planes in and out of an airport.

A news flash reported that the U.S. Congress had approved the president's budget. The traders reacted immediately. The observer asked the traders' supervisor, "What does it mean?"

"The dollar will go up."

The observer thought for a moment. "You know," he said, "the news is wrong. Whoever wrote that clip doesn't understand the American budget system. All that happened was approval of the annual budget resolution. Nothing really matters until the congressional committees get to work on the individual federal agency budgets."

The chief trader responded, "It doesn't matter. All that matters is that all the other currency traders in the world saw the same news. They will all react exactly the same way. Therefore, the dollar will go up."

Reality doesn't matter. To lemmings, all that matters is what other lemmings are doing.

Bankers all over the world bought U.S. mortgage-backed securities because other bankers bought mortgage-backed securities. It was impossible for anybody to untangle the bundles of mortgages to determine which were good loans and which were not. Therefore, many bad loans were made ("subprime" — like rancid meat — a lovely neologism!). Now we have a potentially disastrous "credit crunch," not because banks don't have the money to lend but because banks aren't making loans, well, because other banks aren't making loans. So, just as too many bad loans were made when the herd was stampeding in that direction, now not enough good loans are being made because the herd is stampeding the opposite way.

A strong argument can be made that we are in the mess we are in because we have ignored the painfully learned lessons of the past:

First: Banks are special. If things go sour for the buggy whip business, or the dodo processing industry, even for newspaper publishers, that is a terrible thing and it will have spill-over effects on their suppliers, their employees and the communities where they do business.

But when banks get into trouble, it ruins everything for everybody. What really put the United States on the verge of catastrophe in 1932-33 was the crisis caused by runs on banks. As banks closed in one town after another, panic spread like cholera, killing economic activity wherever it went. People had no money. Whole towns had no money. People couldn't get paid. They couldn't pay their bills. They couldn't buy anything — even a newspaper.

The runs on American banks followed runs on European banks, sparked by the failure in 1931 of the Creditanstalt-Bankverein in Vienna. And it was that particular fandango — the failure of banks, more than the collapse of stock markets — that brought both Franklin Roosevelt and Adolf Hitler to power in 1933. Draw whichever lessons you choose.

There are ways to limit the damage that banks can inflict. We did that with brilliant success from the early 1930s until the 1980s. Financial panic, like pandemic disease, is a well-known phenomenon. Even when we don't know how to eradicate the cause, we do know how to limit the effects, to minimize the casualties: We quarantine the infected.

State and federal legislation — most notably the two Glass-Steagall Acts — sliced and diced the banking industry in several different ways, to quarantine the awful effects on the rest of us when banks got into trouble. In the first place, they restricted interstate banking, which limited the damage a bank could do geographically. Secondly, they erected walls between types of banks, to help encourage bankers to specialize in different kinds of risks and to limit the spill-over effects when banks in one sector got into trouble.

In short, we had three types of banks: Savings and loans, which held savings accounts and made loans for the purchase of residential real estate; investment banks, which bought and sold securities for their customers and underwrote and invested in them on their own account; and commercial banks, which did just about everything else — taking deposits, providing checking accounts, and making commercial and personal loans.

The federal government guaranteed deposits in S&Ls and commercial banks. In theory, there was a limit on how high the guarantee could be, but in reality, the government wrote a blank check — as shown when Continental Illinois went bust in 1984, and depositors were assured they would get their money back, no matter what.

Commercial banks as well as savings and loans were walled off from the securities industry. Securities broker-dealers were not subject to the same kind of regulation as other banks, and their customers did not enjoy any federal guarantees for their assets.

Since the 1980s, all that has been torn down — by Democrats and Republicans pandering to shortsighted bankers who didn't know when they had it good. First, they let savings and loans do things other than make mortgages. They rushed into doing so many other things they didn't know about that we don't really have any savings and loans any more. Then they demolished the interstate banking rules, so all the little banks that knew the local markets and knew their local customers have been gobbled up by predator banks from who knows where, which have no local knowledge at all.

Finally, they destroyed the precious distinction between commercial banks and investment banks, and that is how we got into the mess we are in now.

Memo to Mr. Gorbachev (or whoever is elected president in November): Rebuild that wall!

George H. Lesser has reported for more than 30 years on international political and economic developments for both U.S. and European publications. He has been based in Washington, New York, London and Brussels, and lives in Washington D.C. and Florence, Italy.