Franklin D. Roosevelt Library Cash back? Depositors crowding a bank, Cleveland, Ohio, 1933.

America’s Brewing Debt Crisis

What Dodd-Frank Didn’t Fix

Almost as soon as the financial crisis struck in late 2007, policymakers began working to prevent another one. The roots of the crisis, they contended, lay in reckless lending and excess debt. Banks had made massive loans to “subprime” borrowers, who had little ability to repay them, and the banks funded these investments with borrowed money. When the U.S. housing bubble burst, millions of Americans defaulted on their mortgages, and the overleveraged banks collapsed. The government had to bail them out, and U.S. taxpayers picked up the bill.

In July 2010, U.S. President Barack Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act. Reformers hoped that the act—known as Dodd-Frank, after its Democratic co-sponsors, Senator Chris Dodd of Connecticut and Congressman Barney Frank of Massachusetts—would make another financial crisis less likely. And to some extent, Dodd-Frank has succeeded. During the crisis, too many financial institutions lacked enough capital to withstand losses on their loans. But now, thanks in part to the act, banks have to fund themselves with more capital and less debt, which equips them to absorb more losses in a future downturn. And banks have largely stopped making subprime loans, since Dodd-Frank rules require those who give loans and securitize them to bear some losses in the event they sour.

Nevertheless, during the 2016 presidential campaign, Dodd-Frank has come under attack from both sides of the aisle. In the Democratic primary, Senator Bernie Sanders of Vermont argued that its reforms did not go far enough. He called for the government to break up the largest U.S. banks and reinstate Glass-Steagall, the 1933 act that separated commercial from investment banking, until Congress repealed it in 1999. Republicans, meanwhile, including the presidential candidate Donald Trump, believe Dodd-Frank went too far, and Republican legislators have sought to repeal it at every opportunity, arguing that its regula­tions are crippling U.S. banks and stifling growth.

Both criticisms distract from the real problem with the act, which is that it reckless lending and excess leverage, it misses one of the most important causes of the crisis: “runnable liabilities,” or short-term debt that the govern­ment does not insure. The U.S. financial sector holds trillions of dollars of such debt, including uninsured bank deposits and the short-term liabilities of other financial institutions, such as overnight loans. What makes this kind of debt so dangerous is that during a crisis, short-term lenders, unlike long-term ones, can demand their money back imme­diately, leaving borrowers unable to pay all their creditors quickly. The financial sector stops lending money, credit dries up for consumers and businesses, and the economy grinds to a halt. This is what happened in 2007 and 2008, when massive runs on short-term debt spread panic throughout the financial sector and helped trigger the Great Recession.

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