By Jeremy Lott

Commentary Apr. 26, 2010 - 07:00AM JST ( 5 )

WASHINGTON —

America these days is in one of those Alice in Wonderland moments where the incredible and impossible become all too likely. Case in point: Republicans are seriously arguing that the federal government should break up big banks. No, that wasn’t a typo and we’re not talking backbenchers or windmill tilters here. Senators John Cornyn, Johnny Isakson, Richard Shelby, and John McCain have voiced some support for the reinstating the Glass-Steagall Act, a piece of New Deal legislation whose effective repeal in 1999 allowed American banks to greatly expand in size and scope.

This sudden burst of populist rethinking has been inspired by the Democrats’ push for financial reform legislation. Senate Minority Leader Mitch McConnell has charged that what the Democrats are planning to do to regulate banks represents a “permanent bailout,” through the establishment of a fund to deal with faltering banks. Others have charged that the Chris Dodd-led Democrat plan amounts to the Fannie-and-Freddie-ization of Wall Street, through a narrowed focus of the Federal Reserve and explicit and implicit guarantees. Indeed, Kansas City Fed president Thomas Hoenig wrote in the New York Times this weekend that the bill “deliberately narrows the central bank’s focus to Wall Street alone.”

The problem that both parties are wrestling with is the concept of “too big to fail.” It might not be a big problem for the country if a small number of local banks go bankrupt but if that happened to, say, Bank of America, it would create a problem that simply cried out for government intervention. And the plausible political alternative to the Democrats’ financial regulations, regrettably, does not seem to be less government intervention.

Democrats have charged that America’s recent recession stemmed from Wall Street “greed” and Republican “deregulation.” Several stubborn facts suggest this is a distorted picture of what happened. Banks have been somewhat freed up to compete with other financial institutions but most of their deposits are insured by the Federal Deposit Insurance Corporation and they are still heavily regulated by the federal government. The Department of Housing and Urban Development, activists making use of the Community Reinvestment Act, and Fannie and Freddie all encouraged banks to issue subprime loans, and the Bush administration went so far as to actively discourage banks from requiring significant down payments.

Of course, not all government regulations are created equal, and Republicans, some Fed governors, and not a few public choice economists argue that an orderly bank breakup would be the least bad option. It’s only a slight exaggeration to say they would get around “too big to fail” by eliminating big banking altogether.

The Washington Times reported that in a speech last week, Dallas Fed president Richard Fisher said that the “disagreeable but sound thing to do” would be to “dismantle” large banks “over time into institutions that can be prudently managed and regulated across borders.” And former Fed chairman Alan Greenspan has been more blunt still about big banks. “If they’re too big to fail, they’re too big,” Greenspan said in a speech last year, adding that sometimes forced antitrust breakups of businesses have resulted in the sum of the parts being more valuable than the whole.

Most Senate Democrats and current Fed chairman Ben Bernanke have voiced some willingness to cap the growth of banks but they favor heavy regulation over forced breakups. So, by and large, do the big banks and the movers on Wall Street. Why? Put it this way: Who wouldn’t favor predictability and some government-backed security over having the government carve companies down to size and forcing them to fend for themselves? Taxpayers, perhaps.

RealClearPolitics.com