In 400 words or less:
The professor: Mark Thoma, Guest opinion [more]: Many people associate the onset of the Great Depression with the stock market crash in October 1929. But a more important cause was a series of banking panics in the years prior to the Great Depression, and the particularly severe banking collapse from 1930-1933.
The response to this crisis and the devastating economic disruption that came along with it was the Banking Acts of 1933 and 1935, also known as the Glass-Steagall Acts. The goal was to stabilize the banking system by enhancing the power of the Federal Reserve to regulate financial markets and to intervene when problems emerged.
And it worked. The changes resulted in a very long period, over 50 years, where financial markets remained calm.
That calm is now over, and we are experiencing our worst financial crisis since the Great Depression. What happened? What ended the tranquility? Very simply, financial innovation got ahead of regulation.
The problems we are having did not arise in the traditional banking sector; the problems come from what is called the shadow banking sector. This is comprised of firms such as hedge funds that do just what banks do -- they take deposits, they use the funds to purchase financial assets such as housing loans, and they only keep a fraction of those deposits on hand as cash reserves. But these firms are essentially unregulated and hence subject to the same problems that traditional banks faced prior to the 1930s .
What is the solution to our problems? First and foremost, We need to clean up the mess we are in and do all we can to stop things from getting any worse. Recreating the Resolution Trust Co., as we did in the aftermath of the savings and loan crisis, would be a useful step to take to remove the bad financial paper that is poisoning financial markets.
Over the longer run, it is essential that regulation be modernized. The most important task is to bring the shadow banking sector out into the sunlight, and to put it under the same regulatory structure and safeguards faced by traditional banks.
The last time we restructured our financial system from the ground up, the result was more than 50 years of stability. With a determined effort we can repeat that success and modernize our financial system so that it is substantially less likely to suffer a massive meltdown, but still innovative enough to meet our financial needs.