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Ryan Grim, in a posting January 21 on Huffington Post, states that "a recent poll [a Research 2000 National Poll] found that 47 percent of Americans think Bernanke cares more about Wall Street than Main Street, while only 20 percent think he works for Main Street. Independents, who swung heavily for Brown in Massachusetts, are even more opposed to Bernanke than Democrats or Republicans. Fifty percent of independents think he cares first about Wall Street; 15 percent think he prioritizes the needs of Main Street. That's a difficult vote in the face of an angry public." I'm not familiar with the "Research 2000 National Poll," and do not vouch for its accuracy, but I am sure that a lot of people do think that "Bernanke cares more about Wall Street than Main Street."

I'm sure that's not true. Bernanke is an academic, not a banker. One can criticize many of his decisions, as I have done, but his mistakes, if that is what they are, do not suggest a bias in favor of the banking industry. The reason it looks that way to people who are not well informed about depression economics (which is most people, including not a few macroeconomists) is that beginning in the fall of 2008, his focus has been on restoring the banking industry (including not only commercial banks but also shadow banks, which is to say companies that provide close substitutes for banking services without being regulated as commercial banks) to a level of solvency at which the banks will feel comfortable lending in a risky environment--risky because defaults are way up because of the depression. He (more precisely, the Fed in cooperation with the Treasury Department and the Federal Deposit Insurance Corporation) has done this by (1) encouraging the absorption of the major shadow banks, like Goldman Sachs and Merrill Lynch, into the commercial banking industry, either by acquisition by a commercial bank, as in the case of Merrill, or conversion to a bank holding company, as in the case of Goldman, to reduce the risk of further catastrophic bank failures like that of Lehman Brothers in September 2008; (2) flooding the banks with cash through open market operations (basically buying short-term Treasury securities from banks); and (3) purchasing other securities, such as mortgage-backed securities and Treasury bonds, to keep down interest rates (the greater the demand for fixed-income securities, the higher the price and therefore the lower the yield because the income of each security is, by definition, fixed).

These measures have succeeded to the extent of averting insolvencies of major banks and thus keeping the credit industry alive, and by doing so has prevented an even worse depression than we are experiencing. But a side effect is that some banks, most notoriously Goldman Sachs, cursed with a tin ear for public opinion, have made very large profits in the midst of the depression. By borrowing cheap (because interest rates are so low both because of Fed policy and because lenders are confident that the government will not allow big banks to fail) and using the borrowed capital for risky trades (again in the confidence that the government will not allow a big bank to fail), the banks have been enabled to profit from the depression. This upsets people. But there is no clear alternative that wouldn't make the country as a whole worse off.

Unfortunately, the administration is incapable of explaining the situation to the American people. Maybe it feels they are uneducable in such esoteric matters. (I disagree.) But the consequence is to endanger Bernanke's confirmation. The administration is busy denouncing "fat cat" bankers; Bernanke helped the banks; ergo he prefers fat cats (Wall Street) to thin ones (Main Street). A false syllogism, but hard for the administration to refute, because it is busy bashing bankers.

Bernanke may or may not be the best person for the job. That is almost irrelevant. If he is not confirmed, the independence of the Fed will take a terrible hit, because the next nominee will have to make outright promises to Congress of bank bashing, and of keeping interest rates way down regardless of inflation risk, in order to be confirmed.

The recent announcement of what I'll call the "Volcker Plan" for regulating banks was sandwiched between two major political events: the election of a Republican Senator from Massachusetts and the Supreme Court's decision "deregulating" corporate campaign contributions. The timing of the announcement in relation to the election of the Republican (Scott Bowen) is suspicious: it suggests a desire to change the subject and recapture the populist mandate by attacking the hated banks in a more dramatic fashion than by the proposal for a bank tax that I discussed in my last post. The suggestion that Vice President Biden was a major advocate for the Volcker Plan reinforces the suspicion of a political motivation. He has no background in business, finance, or economics, but is of course an experienced politician. The administration's contention that the plan had been in the work for months and it's just an accident that it was announced the day after the Massachusetts election is hard to believe.

The significance of the Supreme Court decision is that the decision increases the political power of the banks by enabling corporate rather than just individual financing of ads advocating for or against particular candidates in elections. Congressmen may be reluctant to invite an avalanche of negative ads paid for by banks by voting for regulatory measures that might substantially reduce the profitability of banking.

The administration's tough approach creates the following political problem. On the one hand, in continuing the policy of the Bush administration, the administration has been enormously supportive of the banks, and this has enabled some of them to reap large profits despite the depression. On the other hand, it has been criticizing the banks as pigs, with increasing stridency. The more the administration ratchets up its attacks on the banks--escalating from verbal abuse ("fat cat" bankers) to draconian regulation--the more it plays the populist card and, conceivably, distracts the public from the health care donnybrook, but also, the more it retards recovery by distracting bankers and, if tough regulations are instituted, weakening the banks financially and thus discouraging them from increasing their lending. If as a result economic recovery slows, the administration will pay a political price, while if bank regulation flops as health care reform is flopping, the administration will be thought unable to govern effectively.

It is difficult for the administration to rebut charges of being soft on banks because of the continuity not only of policy but also of personnel between the Bush and Obama administrations. The principal theorists of Bush's response to the financial crash were Geithner and Bernanke, and they're still in place. (The third member of Obama's economic troika, Lawrence Summers, is not as prominent publicly as either Geithner or Bernanke.) Geithner is identified in the public mind with hated Wall Street. Bernanke is identified with keeping interest rates way down is encouraging bank speculation (and high profits) just as the Fed was doing (with his support) in the early 2000s. The turn to Volcker is politically adroit, especially in the wake of the increasing skepticism of the Obama administration on the part of independent voters.

In retrospect, from a purely political perspective at least, the administration would have been better off with a different Secretary of the Treasury and a different Federal Reserve Chairman. Not that it could have removed Bernanke; but by deciding to reappoint him, the President in effect ratified Bernanke's policies. Appointing Volcker to succeed Bernanke might have been better from a political standpoint. Volcker is at once a commanding and a reassuring figure, and cannot be accused of being too friendly with hated "Wall Street."

Enough about politics. The Volcker plan deserves careful consideration. It's a shame it was not taken seriously by the administration from the start; the loss of a year is serious, maybe calamitous, because the plan cannot be adopted overnight. Its evaluation, detailed design, and execution will take years.

The plan is being described in some quarters as "the return of Glass-Steagall." The Glass-Steagall Act, passed in the 1930s depression and repealed in 1999, provided that no company could be both a commercial bank and an investment bank. J. P. Morgan's bank had been both; the Act forced its division into Morgan Stanley (investment bank) and J. P. Morgan (commercial bank). The Act did much else besides; and barring commercial banks from engaging in investment banking in the conventional sense of underwriting new issues of securities would not have averted the financial collapse of September 2008. Even before the repeal of Glass-Steagall, moreover, its thrust of separating commercial banking from other financial activities had been blunted by statutory amendments and regulatory (or rather deregulatory) initiatives. It is the spirit rather than the letter of Glass-Steagall that Volcker wants to revive.

Volcker's basic idea is to insulate traditional commercial banking services from risky modern financing practices. Traditional commercial banking services consist of providing a place to park a person's money (a deposit account and safe-deposit box), making mortgage and commercial loans, administering the payments system (essentially, the system whereby a check written on one bank causes an increase in the payee's account in another bank), providing standby (back-up) credit, and buying and selling Treasury securities and other ultra-safe securities. Banks are either local or have local branches, so that they can engage in "relationship" lending--lending based on knowledge of the creditworthiness of particular borrowers, especially individuals and small business. (Big business has other methods of financing besides commercial banks, such as the issuance of bonds or commercial paper, or by drawing on retained earnings.)

As Volcker recognizes, commercial banks, although they no longer account for more than about 20 percent of all lending, play an essential role in meeting the credit needs, especially (by virtue of their ability to engage in relationship banking) of individuals and small businesses, and also by virtue of administering the payments system and providing back-up credit to issuers of commercial paper and other big-business borrowers. Furthermore, they play an essential role in the Federal Reserve's management of the money supply and control of interest rates, because the Fed in normal times varies the money supply by buying Treasury securities from commercial banks or selling Treasury securities to them. (In the first type of transaction, the Fed increases the amount of money in bank balances and in the second, it reduces the supply of money by retiring the money that it receives in the sale.) This makes it easy for the Fed to increase the banks' liquidity, and thus the availability of credit, in the event of an economic downturn. But this will not work if the banks are insolvent.

Volcker's idea is that if the commercial banking system as a whole is insulated from threat of insolvency, even a wave of bankruptcies of other lenders will not have disastrous effects on the financial system and hence the larger economy. The commercial banks will be the sturdy spine of the finance system, which (with the aid of the Fed) will step up its lending if other parts of the financial system, such as the "shadow banks" (financial firms that provide close substitutes for conventional bank services), fail. Federal deposit insurance is already a big step in this direction, because it reduces the likelihood of a run on a bank. The fact that bank regulators have very broad discretionary powers over banks and can close a bank down if they think it likely to go broke, without waiting for actual insolvency, are additional safeguards. But if the bank is simultaneously engaged in high-risk financial activities, such as originating mortgage-backed securities or engaging in speculative trading with its own capital, the conventional safeguards won't be effective; the banks may still go broke en masse.

That's the thrust of the Volcker Plan, though the version just embraced by the administration is somewhat more limited. The plan (in the form in which I think Volcker himself envisions it) has a lot to commend it, but it has three big drawbacks, which need to be addressed.

The first is that limiting the services that commercial banks can provide is apt to result in a continued shrinkage of commercial banking relative to other finance, possibly to a point at which commercial banking is no longer a large enough industry to constitute the spine of the financial system.

The second and related point is that the commercial banking industry probably is not large enough to fill the hole created by a collapse of the shadow-banking industry. It was the collapse of Lehman Brothers, which was not a commercial bank, that precipitated the most acute phase of the financial crisis of 2008. So the shadow banks need tighter regulation. Whoever regulates the shadow banks (at present, regulation is divided among the Federal Reserve, because the main shadow banks have either been converted to bank holding companies or acquired by banks, the Securities and Exchange Commission, and the state insurance commissioners), however, is likely to be in continuous dispute with the commercial-banking regulatory authority or authorities. The commercial banks will want the shadow banks reined in as tightly as they (the commercial banks), and the shadow banks will resist.

The third problem is the sheer complexity of the giant multiservice banks and the difficulty of carving them up by removing the parts that do not engage in traditional commercial banking.

A possible fourth problem is that there may be significant economies of scope in the combination of differential financial services with commercial banking. But I emphasize "may be;" I don't think there's good evidence one way or another. This uncertainty is a compelling reason for a very careful, nonpolitical study of the Volcker Plan, rather than a rush to adopt and implement it. The sharply negative reaction of the stock market to the announcement of the plan would ordinarily hold little significance. But now that common stocks are a big part of people's wealth (whether in the form of direct ownership of shares or indirectly through pension plans, college-savings plans, and other investment vehicles), any drop in the stock market reduces people's assets, making them reluctant to spend; and any curtailment of spending slows the pace of economic recovery. There is a social value, therefore, to "reassuring" the stock market that any restructuring of the banking industry will proceed in a deliberate and thoughtful manner (as undoubtedly intended by Volcker), rather than in a spirit of vengeance against "Wall Street."

On January 3, Fed chairman Ben Bernanke gave a long speech entitled "Monetary Policy and the Housing Bubble," in which he argued that the Fed's low interest rate policy in the early 2000s, which he supported, was not a significant factor in the housing bubble and resultant financial collapse. His arguments are unsound, self-serving, and harmful to economic recovery and financial regulatory reform.

John Taylor, in an op-ed in The Wall Street Journal on January 11, notes a number of the errors in the speech. Other errors have been pointed out in economists' blogs. The basic argument that Bernanke makes is that forecasted inflation at the outset of the 2000s was so low that pushing the federal funds rate way down (in fact, into negative territory in real--that is, inflation-adjusted--terms) was a prudent measure for stimulating the economy. And, Bernanke adds, although reducing the federal funds rate did lead to an increase in mortgage rates (even though the federal funds rate is short term and the mortgage rates long term at least in traditional 30-year fixed-payment mortgages, as distinct from the adjustable-rate mortgages that became popular during this period), the increase was too small to explain the extraordinary increase in housing prices. (So at least Bernanke acknowledges a link between short-run and long-run interest rates; his even more defensive predecessor as chairman of the Fed, Alan Greenspan, does not.)

The Fed's forecast was inaccurate (Taylor points out that private forecasts contradicted it). But accurate or inaccurate, the result was a huge increase in investment in housing, which pushed up housing prices. The increase in prices was inflationary. Negative interest rates are likely to cause inflation by flooding the economy with money, raising the ratio of money to output. The Fed was fooled because the flood of money, rather than creating a large surge in the consumer price index (in part because cheap foreign imports kept prices of most goods down), created asset-price inflation--and the principal asset inflated was housing. The Fed wasn't looking for asset-price inflation, and didn't see it.

Housing is a product bought primarily with debt (a long-term mortgage for between 80 and 100 percent of the market value of the house), so a fall in interest rates pushes up housing prices by increasing the demand for housing. It also leads to a reduction in mortgage standards, because when housing prices are rising, defaults decline, making risky mortgages less risky. In addition, very low interest rates stimulate lenders to make risky loans in order to maximize yield; hence house financing increasingly took the form of subprime mortgage lending. (When interest rates are very low, low-risk loans are not very profitable, and it is attractive to increase yield by making riskier loans.)

A housing bubble is extremely dangerous, as the Japanese learned in the 1990s. Mortgage debt is enormous, and entangles the banking industry deeply in the housing industry. Not all housing bubbles trigger collapses of the banking industry, of course, but a competent central bank would be alert to warning signals of a possible housing bubble. The Federal Reserve, first under Greenspan, then under Bernanke, was not alert; it was asleep.

Bernanke's claim that abnormally low interest rates cannot explain the entire increase in housing prices suggests a misunderstanding of the bubble phenomenon. A bubble is a self-sustaining increase in asset prices. People see prices rising, assume they will continue rising at least for a time, and jump on the bandwagon. An external stimulus, such as a continuing drop in mortgage interest rates, is not required to keep the bubble expanding. Bernanke acknowledges that "for a time, rising house prices became a self-fulfilling prophecy," but he argues that what got the bubble started was not low interest rates but the deterioration in lending standards. He does not acknowledge the possibility that low interest rates accelerated an existing trend to higher house prices, that rising house prices by reducing defaults led to riskier lending, that the search for yield in an environment of low interest rates also contributed to the increase in risky lending, and that these factors--all stemming from too-low interest rates generated by unsound monetary policy--were, in combination, responsible for the bubble.

Bernanke exonerates monetary policy, and places blame instead on the lenders for risking lending, on the "global savings glut" (the increase in the U.S. monetary supply because of large purchases of Treasury securities by China and other countries that have large dollar reserves because they export much more than they import), and on imperfect execution by bank regulators (including the Fed) of their authority to prevent risky lending. Higher interest rates that would have burst the housing bubble would also, he argues, have slowed economic activity in general, and better regulation of risky lending practices would not, and so his preferred combination would be very low interest rates with stricter regulation of banks (and other lenders). But stricter regulation of lending would have reduced the amount of credit available in the economy, which would have slowed economic activity. As for the availability of foreign capital, while it facilitated investment in housing, it did not disable the Fed from raising interest rates, as it finally did, to burst the bubble--after the bubble had become so large that its bursting was a disaster.

I am unclear why Bernanke is so defensive about monetary policy, while acknowledging (albeit very briefly) failures of regulation for which he also bears considerable responsibility. The regulatory failure, however, is shared with other regulatory agencies, such as the SEC. And the regulation of the money supply (and hence of interest rates) is the very core of the Fed's responsibilities; if it is incompetent at that task, it may require some profound overhaul.

Another regulatory failure goes unmentioned. Even if the Fed's monetary policy was not responsible for the bubble, the Fed should have been alert to the possibility of a bubble, and should have taken measures either to burst it before it got too large, or to insulate the banking industry from the consequences of a burst. The Fed--Greenspan's Fed, Bernanke's Fed--was asleep at the switch.

The timing and content of Bernanke's speech cannot be separated from his uncomfortable position of being up for confirmation by the Senate for a second term as chairman of the Fed. He bears, in my opinion, a considerable responsibility for the current dreadful state of the economy, not only by his lack of foresight concerning the housing bubble and his complicity in Greenspan's mismanagement of monetary policy, but in his failure to grasp the severity of the looming financial crisis even after Bear Stearns collapsed in March 2008. The result of that failure was that he was taken by surprise when the other financial ninepins fell in September and failed to grasp the importance of keeping Lehman Brothers from collapsing. He then regained his balance. But much damage to the economy had been done.

It is natural, especially while the Senate's determination whether to confirm him is pending, that Bernanke should avoid accepting blame for the economic mess we're in. But it has the bad effect of feeding the populist theory of the economic depression--that it was the work of greedy and reckless bankers. Of course it was the collapse of the banks that triggered the depression, and the collapse was the proximate result of decisions made by the bankers. But as I argue in my new book (in fact in both books), the bankers were doing what businessmen always do, which is to try to maximize profits within the framework of permissible profit-maximizing conduct created by government. Because government regulation of the money supply and of lending practices was defective, the bankers' pursuit of profit maximization led the economy over the brink. If the framework is not reformed, we are at risk of experiencing a future financial crisis of equivalent severity to this one. Bank taxes and limitations on bankers' compensation may assuage the public anger stirred up by a populist theory endorsed by government officials, but they will not prevent future crises.

Photo credit: Win McNamee/Getty Images

Paul Volcker has suggested, as has Mervyn King, the Governor of the Bank of England (the U.K.'s version of the Federal Reserve), along the lines of the Public Utilities Holding Company Act or the Glass-Steagall Act, both passed in the 1930s and since repealed, that commercial banking (including lending by thrifts, and probably by money-market mutual funds as well) be separated from proprietary trading and other high-risk financial activities.

The reasons are several. One of course is the contagion of the kind that brought down Lehman Brothers; unless risky and safe activities are conducted in strictly separate subsidiaries--which is difficult to do without sacrificing whatever benefits flow from having both types of activity in the same enterprise--the assets involved in the safe activities will be available to the creditors of the risky activities. Not that banking can ever be completely safe, given that its essence is borrowing short and lending long, but it can be made much safer than it is.

Another reason for separating out commercial banking besides the contagion effect is the awkwardness of trying to merge disparate business cultures in a single firm. The combination is likely to be unstable if the different cultures have different risk profiles. A safe, conservative banking operation will attract a different type of executive from a speculative trading operation. The banker will be more cautious and, because of the positive correlation between risk and return, will be differently--and less munificently--rewarded. The greater profitability and more generous remuneration of the traders will nudge the bankers (or induce top management to pressure them) to increase the profitability of their own operations, which will require their taking greater risks. Thus the separation of commercial banking from other financial activities would automatically solve the problem for which limiting the amount or structure of compensation of financial executives is proposed as the solution. A career in a "safe" bank would not draw persons with a taste for risk.

There would be additional, and even greater, benefits to making commercial banking safe by forcing banks to divest their risky, nontraditional banking activities and thus creating a dike against inundation from a collapse of other parts of the financial system. Although nowadays commercial banks supply less than a quarter of the total amount of credit in the United States, they play a unique role. They provide essential financing for small- and medium-sized businesses (what is called "external finance")--businesses too small to meet their own financing needs out of retained earnings or by issuing bonds or commercial paper, or to be attractive to a lender that does not have an established relationship with the borrower which would enable the lender to evaluate the borrower's creditworthiness. If a bank fails, though other lenders remain, borrowers from the bank may find it difficult to establish the kind of personal relationship with a new lender that would reassure the lender that the borrower was creditworthy.

Relationship banking declined during the current depression not only because of fear of default and a fall off in demand for loans, but also because the relationships that sustain relationship banking had withered in banks that had embraced the new model of originating and purchasing securitized debt. Creating securitized debt for a fee, or buying securitized debt, involves no relationship with the debtor. (This is an argument for limiting securitization by commercial banks.)

Banks also provide standby lines of credit that provide emergency funding when other sources of credit fail, as happened when the commercial-paper market froze in the wake of the collapse of Lehman Brothers and the near insolvency of other broker-dealers that had been intermediaries in that market. (Issuers of commercial paper normally have standby lines of credit from commercial banks, should the usual purchasers of their paper defect, as Lehman did.) Banks thus back up the riskier lenders.

And they are the normal conduit by which the Federal Reserve pumps cash into the financial system in order to increase the amount of lending, whether by lending money to banks directly or more commonly by buying short-term Treasury securities from them (or lending money to the banks, taking the securities as collateral, by means of repossession agreements), thus increasing their lendable cash. (Put differently, the commercial banks are the instruments by which the Fed regulates the money supply--in normal times, at any rate.) It is easier for the Fed to recapitalize a bank than to recapitalize other types of financial institution. And the Federal Deposit Insurance Corporation has authority and expertise that enables it to close a failing bank and transfer its assets to another bank with minimal disruption of its business.

Were commercial banks forbidden to affiliate with other entities, the danger of a financial crisis that would engulf the commercial banking sector would be minimized. Even when a nationwide housing bubble bursts and mortgages are a significant component of the asset portfolios of most banks, with the result that the capital of most banks is impaired, the Fed can prevent their collapse by pumping cash into them. In fact the primary victims of the banking collapse of September 2008 were not commercial banks but other financial intermediaries.

Part of the reason is federal deposit insurance, which protected most commercial banks from the runs that brought down Bear Stearns and Lehman Brothers and would have brought down Merrill Lynch, Morgan Stanley, and Goldman Sachs within days of Lehman's collapse had the government not intervened by arranging the sale of Merrill to the Bank of America and the conversion of the other two firms to bank holding companies, which placed them under the Federal Reserve's regulatory authority and thus gave them access to the "discount window"--which just means, made it easy for them to borrow money from the Fed. This option reassured investors and stopped the run that was threatening to deprive the firms of the short-term capital that they needed in order to continue in business.

With the commercial-bank industry sealed off from other financial intermediation, the Federal Reserve's independence would be protected. It would, as it did until the financial crisis of 2008, be operating solely within the orbit of commercial banking--quietly regulating commercial banks and moving interest rates up and down by esoteric means (how many people know what "open market operations" are?). The Fed would not be making life and death decisions regarding the huge Wall Street firms, as when it refused to provide financial CPR to Lehman Brothers--firms that whether called banks or bank holding companies or something else are engaged primarily in speculation rather than in banking in the sense described above. There is nothing evil about speculation, as ignorant people think, but it can create macroeconomic risk, and that is a powerful reason for separating it from commercial banking.

That would leave the question of what to do with those shadow banks. Stripped of their connection to commercial banking, they would again fall under the regulatory aegis of the SEC, which is notable for a lack of expertise and even interest in macroeconomic risk. The simple answer would be to create a new division in the SEC that would be responsible for macroeconomic risk regulation of firms regulated by the commission. There is time to form such a division and bring it up to speed, since the major shadow banks, as a result of the convulsions of 2008, are no longer regulated by the SEC; apart from Lehman, which was liquidated, they were either bought by commercial banks or converted to bank holding companies, and in either case are now regulated by the Fed and other bank regulatory agencies.

Money-market funds are a type of mutual fund, regulated by the SEC, that provide checkable accounts that pay higher interest than demand-deposit accounts in commercial banks. They earn the interest out of which they pay interest to their account holders by investing in commercial paper and other short-term securities. After a run on money-market funds began following the collapse of Lehman Brothers, in whose commercial paper some of the funds were heavily invested, the federal government provided temporary insurance of the accounts. Money-market funds, like thrifts (mortgage banks), are so similar to commercial banks that all three types of financial institution probably should be regulated on the same principles, emphasizing safety and therefore separation from other types of financial institution. Separation would eliminate the need for a "systemic-risk regulator." Commercial banks would not be a source of such risk; the sources would be under the regulatory aegis of the SEC.

I said that the separation of commercial banking from other financial intermediation should be considered--not that it should be ordered forthwith. It would be a formidable undertaking, fiercely opposed; and the argument that separation would sacrifice significant economies of scale and scope, while unsubstantiated and rather implausible (think of Citigroup and Bank of America, whose travails seem to have been amplified rather than diminished by the scope of these banks' activities), would have to be carefully appraised.

Merely reenacting the Glass-Steagall Act (and repealing the statute that repealed it)--the New Deal statute that separated commercial from investment banking--would not avoid the complexities involved in divestiture. As explained by Robert Pozen ("Stop Pining for Glass-Steagall," Forbes, Oct. 5, 2009, www.forbes.com/forbes/2009/1005/opinions-glass-steagall-on-my-mind.html (visited Oct. 13, 2009)), "Even under Glass-Steagall commercial banks could invest in bonds, manage mutual funds, execute securities trades on the order of their customers and underwrite government-related securities. The main thing they couldn't do was underwrite corporate stocks and bonds...The main impact of repealing Glass-Steagall was to allow banking organizations to become more active in underwriting." So a greater rollback of financial deregulation than merely re-enacting the Glass-Steagall Act would be necessary for a clean separation of commercial banking from other financial intermediation. (Greater, but in one respect lesser, as there is no good reason to forbid commercial banks from underwriting securities issues, a central prohibition in Glass-Steagall.)

Such a rollback is conceivable, if barely, but there is a further hitch, as Pozen goes on to explain in the piece that I quoted from: "The repeal of Glass-Steagall facilitated the rescue of four large investment banks and thereby helped reduce the severity of the financial crisis. When Bear Stearns and Merrill Lynch got into serious trouble, they were promptly acquired with federal assistance by JPMorgan Chase and Bank of America, respectively. These rescues happened only because banks could own full-service broker-dealers. When Goldman Sachs and Morgan Stanley were challenged to find adequate short-term funding, they were allowed to quickly convert from broker-dealers into bank holding companies. Banks have a significant advantage over broker-dealers in obtaining short-term financing in illiquid markets.

A bank can rely on insured deposits and Fed loans as well as short-term financing in the form of commercial paper. Commercial paper buyers are a fickle bunch. Bank depositors are more stable retail customers." All true; but the Federal Reserve can lend to a firm that is not a commercial bank, even if the borrower has lousy collateral (Bernanke's argument that it cannot do this is not a persuasive interpretation of the Federal Reserve Act); it can also guarantee the borrower's debts. It is not obvious that these are inferior solutions in an economic emergency to forcing a merger with a bank.

(Photo: Getty Images/Timothy A. Clary)