Melvin I. Urofsky: The Value of "Other People's Money"

Published January 7, 2009 in the New York Times.

Some things never change. When President Obama spoke last week of “shameful” bonuses for bankers and the financial community’s “irresponsibility,” he echoed charges leveled nearly a century ago by Louis D. Brandeis. Brandeis, a commercial lawyer, leading reformer and future Supreme Court justice, described a dangerous combination of avarice, lack of accountability and poor oversight in “Other People’s Money, and How the Bankers Use It,” one of the best-known exposés of the Progressive era.

Published in 1914, the book was based on the revelations of the House of Representatives’ Pujo Committee about the predatory practices of J. P. Morgan and other big bankers. “Other People’s Money” influenced both Woodrow Wilson’s New Freedom agenda and Franklin Roosevelt’s New Deal. It also offers valuable lessons for today.

Our current crisis, after all, was in part fueled by bankers making big gambles with other people’s cash. They bundled and sold sub-prime mortgages, took their profits, and then left others holding portfolios full of worthless, even toxic, paper. This was exactly the kind of behavior that Brandeis despised. He believed that it was one thing for an individual to put up capital in risky ventures, playing to win but prepared for failure. But he saw the bankers of his time dodging failure by manipulating the marketplace at the expense of smaller entrepreneurs and consumers.

As president, Wilson tried to put a stop to this. He read the book and called Brandeis in to help draft three bills crucial to the New Freedom agenda — the Federal Reserve Act, the Clayton Antitrust Act, and the law establishing the Federal Trade Commission. These measures allowed Congress to take away banks’ control over currency, banned interlocking directorates (in which banker representatives controlled other corporations), and established rules of fair competition.

Banks found it relatively easy to get around these rules in the 1920s, especially with Republican administrations that did not seem to believe in market regulation. Bankers promoted the purchase of stocks on low margins or down payments, often as little as 10 percent of the price, and then financed the difference by loans, while their brokerage divisions sold the stocks. Then the stock market collapsed in the fall of 1929, taking the banking system down with it.

During the Great Depression, people turned to Brandeis once again. “Other People’s Money” was reissued in an inexpensive edition, and many of those who came to Washington to work on Franklin Roosevelt’s New Deal read it. The New Deal laws, particularly the Glass-Steagall and the Securities Exchange Acts, imposed long overdue regulation of the banking system, required the separation of banking from stock brokerage, and established the Securities and Exchange Commission to regulate the stock markets.

For Brandeis, regulation was not supposed to be a restraint on innovation or the entrepreneurial spirit, but rather a check on unbridled greed. He believed in a free market, but one in which the government enforced rules of fair competition so that the most talented could succeed. Clear rules would help ensure that business was conducted fairly and openly.

“Other People’s Money” can help us navigate the new era of regulation that we are likely to enter. It would be wise for Mr. Obama to heed Brandeis’s advice before imposing stricter rules on banking and the stock market. For these plans to be effective, Brandeis would caution, they must be more than cosmetic. Government should oppose banks’ purchases of stock brokerages, for example, to avoid the problems that Brandeis exposed. Furthermore, new rules won’t accomplish much without effective watchdog agencies. The Securities and Exchange Commission, for example, seems to have abandoned its oversight responsibilities during the Bush years, and now, we are paying the price.

As we reel from the financial crisis, “Other People’s Money” and similar indictments of immoral banking behavior will likely find a new audience. Some of the trouble-making bankers will, perhaps, be temporarily chastened. But before we know it, they will once again be complaining about regulation’s “interference” with the market. Don’t listen to them. Good regulation will keep us from losing sight of the importance of those same principles that Brandeis emphasized so many years ago — honesty, openness and a fair playing field.

Melvin I. Urofsky is a professor at Virginia Commonwealth University and the author of the forthcoming “Louis D. Brandeis: A Life.”