Glass-Steagall: The Tories' Clause IV moment

Having failed to ignite for a long time, the "Glass-Steagall" debate has now caught fire. For months, the big names of Wall Street and the City have done everything possible to douse the flames of open and honest discussion. But now, the logic of common sense burns brightly.

In recent weeks, an ever-growing number of financial luminaries have said what this column has argued for years. We can't just rely on re-regulating our existing banking sector. Radical reform is needed. And despite our lily-livered politicians' efforts, the intellectual tide is now turning.

The "Glass-Steagall" firewall between commercial banks (that take deposits) and investment banks (that take big risks) was incrementally removed in the UK and US during the late 1980s and 90s - an "innovation" mimicked across the Western world. Since then, our financial markets have lurched from crisis to crisis.

Once the Depression-era legislation was repealed, and the divide gone, investment bankers were then able to use taxpayer-backed deposits to take ultra-risky bets, safe in the knowledge they'd be rescued if their bets back-fired. No single act has done more to destabilize our financial system and turn "sub-prime" from a banking crisis into a fiscal crisis too.

We urgently need to re-impose the firewall - separating commercial "utility" banks safeguarded by government from lightly-regulated investment banks that would then be exposed to the full force of the market. At a stroke, our banking system would be far safer and the "too big to fail" issue solved.

Needless to say, this is anathema to the "universal banks" of the City and Wall Street who rely on government cash for survival and from whom politicians, in turn, receive campaign donations and cushy banking jobs once their political careers have expired.

It was at this disgraceful, corrupt consensus that Mervyn King earlier this month hurled a well-aimed grenade. In a speech of historic importance, the Bank of England governor boomed that Glass-Steagall's removal, and the "breath-taking" scale of the bail-outs, had created the "biggest moral hazard in history".

Other important voices have since joined him. George Soros, the supremely influential financier, now agrees that there "has to be internal compartments that separate proprietary trading from commercial banking".

Two leading US regulators, during Congressional testimony last week, also dared to annoy the "titans" of Wall Street. Both Sheila Bair, Chairman of the Federal Deposit Insurance Corporation and John Dugan, Comptroller of the Currency, argued for "thicker walls" between commercial and investment banking.

John Reed, the Former Citigroup Chairman, meanwhile said a new Glass-Steagall would "go a long way towards building a more robust financial sector". This is highly significant - seeing as Citigroup was effectively formed by a merger facilitated by Glass-Steagall's removal.

Rob Rubin, who as Bill Clinton's Treasury Secretary pushed for the law change, then went to work at Citigroup, where he "earned" tens of millions of dollars. Nice work if you can get it. US taxpayers have since extended a $45bn bail-out to the massively indebted bank.

Politicians have reacted to King's "outburst" with arguments revealing their tenuous grasp of finance. "Lehman was a pure investment bank," they say, "and that failed". Yes, but had the entire banking system not been riddled with bad bets and leverage, Lehman's collapse would never have posed even the slightest "systemic danger". The core banking system would have been sound.

"Conventional banks failed even before Glass-Steagall was repealed", the government's pet commentators opine. Of course they did, but the bail-outs were infrequent and tiny compared to those today, as the losses weren't magnified by leverage.

The universal banks now argue it's impossible to draw a line between investment and commercial banking. As King says: "It's hard to see why". The reality is that existing regulations already distinguish between different bank functions when determining capital requirements.

"People say I'm old-fashioned," said Former Federal Reserve boss Paul Volcker last week, in comments backing-up King. "They say banks can no longer be separated from non-bank activity - but that argument got us to where we are today".

Our financial system has been saved from disaster, for now. But in no sense has it been fixed. Ministers are making belated efforts to increase competition among High Street banks, as the Sunday Telegraph reports today. Alas, this is a side-show. Until there's a Glass-Steagall type firewall, another banking crisis looms.

George Osborne maintains we can get away with tweaking the existing system. Behind the scenes, though, the Shadow Chancellor is "considering" re-imposing Glass-Steagall. The Tories worry, though, that if the UK did this unilaterally, the City would become "uncompetitive".

Mr. Osborne needs to get out more. Across the world, leading investors are sick of systemic dangers. In places like Beijing and Abu Dhabi, there is a growing fear that the UK will be rendered insolvent, and go the way of Iceland. By leading the charge towards a new Glass-Steagall, a Tory government could do a great deal to restore London's name as a global centre of financial stability and regulatory excellence.

Courage is, anyway, contagious. Just look at the quality of the people now lining-up behind Mervyn King, not least in the US, once the Governor took on the vested interests against Glass-Steagall. The Tories should keep that in mind.

This is a defining issue. Has our Chancellor-in-waiting got the guts to do the right thing, even though it will incense his parties' traditional City supporters? Think carefully Mr Osborne. This could be your "Clause IV" moment.

US GROWTH NUMBERS NOT THE FULL STORY

The emerging giants of East are rising, but what's happening in the US still dominates global economic sentiment.

So I was pleased last week when I heard that, after four successive quarters of contraction, America's economy grew by an impressive 3.5pc between July and September, compared to the quarter before. "The US is out of recession" numerous newspaper headlines screamed. No wonder share prices surged.

As ever, the numbers warrant a closer look. For one thing, this is annualized data. So the US economy actually expanded by only 0.9pc during the third quarter - a fact most newspaper reports ignored.

What growth we did see resulted from a 3.4pc annualized rise in US consumption between July and September, which was in turn caused by a 22.3pc spike in spending on consumer durables.

That increase, though, was largely driven - quite literally - by last-minute vehicle purchases under the soon-to-expire "cash for clunkers" scheme. The much-trumpeted rise in residential construction - the first in four years - was also dependent on a temporary tax credit for first-time buyers.

In other words, this latest US growth spasm stemmed from one-off government "giveaways" - with the public only able to take advantage of such gimmicks by going deeper into debt. The rise in US consumption coincided with a 3.4pc fall in household disposable income and a plunging savings rate too. With government and household debt spiralling anew, America's so-called "return to growth" is nothing but a return to higher leverage.

Consumer spending makes up 70pc of the US economy. So we should all be concerned that after a "euphoric" third quarter, the mood darkened significantly this month. The respected Conference Board measure of consumer confidence just plunged to a 26-year low, which is hardly surprising. US unemployment, now at its highest since the early 1980s, is still rising fast.

Extremely weak consumer sentiment is a stark reminder of how fragile the world's largest economy remains, not least as the "bold" stimulus measures subside. The grim reality is that America isn't out of recession, whatever your stock broker tells you. Over the last 40 years, all US slumps have been interrupted by at least one quarter of positive growth, followed by a renewed downturn.

America hasn't yet recovered and it won't anytime soon - not unless President Obama finds the courage to hose down his friends in the banking sector and force them to start lending.

Liam Halligan is Chief Economist at Prosperity Capital Management