Given the Republicans’ success in painting the Democrats as the party of Wall Street, it was inevitable that the Obama Administration would announce some measures aimed at bringing the banking sector under more effective control. But the smart money would have been on a symbolic gesture, such as an ineffectual limit on bankers pay.

The announcement today that banks are to be banned from undertaking proprietary trading operations may have proved the smart money wrong. Certainly the sharp drop on Wall Street suggests that the announcement delivers more than expected for the public, and correspondingly less for the shareholders of big financial institutions.

If it is delivered as described, it would force the reversal of the 2008 move by Goldman Sachs and Morgan Stanley to become bank holding companies, with direct access to support from the Federal Reserve and Federal Deposit Insurance Corporation. More generally, it would be a significant move in the direction of narrow banking, preventing publicly guaranteed banks from engaging in the kind of high risk trading that produced the current financial crisis. As Chris Joye points out, narrow banking has surprisingly broad support among economists.

But will it be carried through? The first problem is the dysfunctional US political process, which prevents just about anything from happening. Obama might be able to wedge the Republicans on this issue, but they will probably find an excuse for voting en bloc against any measure he proposes. Under the current Senate supermajority rules that would be enough to stop any reform.

So, it will probably be necessary to scrap the filibuster and pass legislation with a simple majority. And that’s assuming that Obama can command the support of the numerous Democrats who are beholden to Wall Street, just as the Republicans (hypocritically, given their own position) allege.

Leaving aside the political obstacles to getting legislation passed, there’s the problem of making it effective. Even if banks aren’t allowed to own speculative investment enterprises, they can make big money lending to such operations. Then when things go bad, the failure of one or more big speculators can imperil the system as a whole. That’s what happened in 1998 with LTCM.

What matters here is the political dynamic. If the aim is to get back to business as usual as fast as possible, any reform will be short-lived and ineffectual. On the other hand, if there is a permanent shift in public and political sentiment against an economy dominated by the finance sector, things will work out very differently. Instead of eroding control, the discovery of loopholes will lead to tighter and more systematic regulation ending in a full-scale separation of banking and speculative finance.

One sign for optimism is the progress being made on the related issue of tax havens. Until very recently, moves to control the activities of tax havens were almost entirely ineffectual, at most prompting wealthy tax dodgers (and the banks who hid the money for them) to shift accounts from one jurisdiction to another. But as governments have run short of money and tolerance, the picture has changed. A combination of economic/diplomatic pressure on tax havens and a willingness to make use of whistleblowers within banks has rendered international tax evasion far less viable.

Perhaps this time Wall Street really will be cut down to size. If Obama’s Administration is to recover from its current malaise, he needs to win on this one.

I wrote this for Crikey. It should be appearing there soon, I expect