Former Senior Economist on the President’s Council of Economic Advisors: Laurence Kotlikoff has a plan for banking reform!

Posted on April 28, 2010 by

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On Tuesday April 27th, I attended a seminar at the Carnegie Endowment for International Peace in Washington DC.  The event was a presentation of prominent economist Laurence Kotlikoff’s new book in which he makes a case for radical banking reform. 

The book received praise from 5 Nobel Laureates in Economics:

“Jimmy Stewart Is Dead is a page-turner, as fast moving as the Simpsons, with new insights on every page. As fun as it is, Jimmy Stewart is also deadly serious. It describes the deep problems of our financial system, with its ubiquitous and dangerous overhangs of different forms of debt. Laurence Kotlikoff prescribes the regulatory and banking overhaul needed to prevent another financial crash. His book should be read by everyone who wants to ensure that such a crisis will never occur again.”

— George Akerlof, Koshland Professor of Economics, University of California at Berkeley,
Nobel Laureate in Economics

“Larry Kotikoff’s book makes an impassioned, coherent, and (to me) convincing case for Limited Purpose Banking.”

— Robert E Lucas, Jr., Professor of Economics, University of Chicago, Nobel Laureate in Economics

“This book is ‘must’ reading for everyone who cares about the future of the American economy. “

— Robert W. Fogel, Charles R. Walgreen Distinguished Service Professor of American Institutions, The University of Chicago Booth School of Business, Nobel Laureate in Economics

“Kotlikoff is right. Unless we institute fundamental reforms, there will be an even greater crisis than the current one. This well-written book is a must read for those concerned with reforming the financial system.”

— Edward C. Prescott, W. P. Carey Professor in Economics, Arizona State University, Nobel Laureate in Economics

“Certainly we need to abandon the hazardous financial system we have. Kotlikoff’s Limited Purpose Banking plan, with its ban on borrowing by financial limited liability companies, is one of the best visions to surface so far.
— Edmund Phelps, McVickar Professor of Political Economy, Columbia University, Nobel Laureate in Economics

The following is a summary of Dr Kotlikoff’s plan to avoid some of the circumstances that could lead to another financial crisis. 

The case for Radical Banking Reform

Laurence Kotlikoff

A presentation of Laurence Kotlikoff’s new book:

Jimmy Stewart is dead

Ending the world’s ongoing financial plague with limited purpose banking

Laurence J Kotlikoff  is a William Warren Fairfield Professor at Boston University, a Professor of Economics at Boston University, a Fellow of the American Academy of Arts and Sciences, a Research Associate of the National Bureau of Economic Research, a Fellow of the Econometric Society, a former Senior Economist, President’s Council of Economic Advisers, and he is also President of Economic Security Planning, Inc.

In his new book, Mr. Kotlikoff proposes to replace the fractional banking system widely used today with “limited purpose banking”.  Mr. Kotlikoff makes the argument that an industry wide reform of the banking system will yield much better results than the kind of government financial regulation currently being proposed by US lawmakers.  Laurence Kotlikoff proposes a “radical yet safe banking reform”. 

In Kotlikoff’s own words: “Suppose there were catastrophic banking losses again, the government would print trillions of dollars to cover the losses and the FDIC would guarantee to replace banking customers their money, but what the government does not insure you for is the resulting hyperinflation.  Even if the FDIC guarantees your deposits, your purchasing power would drop tremendously, rendering your dollars worthless.  FDIC is nominal, government cannot insure in real terms. The federal government is trying to guarantee things that it can’t guarantee.”

 In the case of insurance companies (ex: AIG), Kotlikoff adds: “In the case of a life insurance company, there’s a pool of money that only pays out individuals who die.  Suppose there was a huge outbreak of a deadly disease and millions died, the insurance would have the obligation to payout for all the policies they had issued and the insurance company would probably not survive such a crisis.”

To avoid such a doom’s day scenario, Kotlikoff proposes that banks act strictly as “honest” intermediaries and stop “gambling” with savers deposits.  The funds would go from savers to borrowers.  Banks would sell mutual funds (equity financed).  There would be a cash mutual funds used for a payment system (acting in a similar role as that of checking accounts), insurance mutual funds etc… Kotlikoff argues that mutual fund companies did not suffer much in the financial crisis.  They were somewhat immune to the “financial earthquake”.  Kotlikoff proposes a single regulatory agency: The Federal Financial Authority, which would be responsible to verify mutual funds, appraise collateral, issue a sound rating system, disclose information real time on the internet, and implement an auction system for buyers and sellers (a marketplace for loans).  Transparency and full disclosure is absolutely necessary.

Douglas Elliott

Douglas Elliott is a fellow at Brookings for economic studies, initiative on business and public policy.  He was an investment banker for two decades, principally at J.P. Morgan. He was president and principal researcher for the Center on Federal Financial Institutions. He focuses on issues surrounding both public and private financial institutions.

Douglas Elliott: “Not every brilliant theory works in the real world”

Mr. Elliott is convinced that Dr Kotlikoff adventure in a new world of banking would give up some major advantages of the current system such as maturity transformation, contingent commitments and that Dr Kotlikoff underestimates the transition risk.  Mr. Elliott argues the following:

  • Under limited purpose banking, credit will be less available and relatively expensive
  • Lots of bad regulation will go away but government will be involved and play a critical role through this concept of a Federal Financial Authority.
  • Most of the causes of the crisis would not disappear under Kotlikoff’s proposal:
    • There won’t be an improvement in terms of reducing or eliminating perverse compensation incentives (greed that led to the financial crisis)
    • Bubbles will still exist

Elliott dismisses Kotlikoff’s plan as “interesting but needs too much refinement to work in the real world.  Limited purpose banking would come at the tremendous cost of a loss in economic efficiency for a safer system”

Conclusion

Mr Kotlikoff responded with the following arguments:

  • Maturity transformation is highly overrated.
  • The availability of credit is not a real problem in the transition process.  Banks just act as intermediaries, as long as there are savers willing to lend, there will be credit available for borrowers.
  • The need for a relatively “safe” system is paramount.  Individuals need to know that they can rely on the system.  The psychology is what brought on the financial crisis, sure there were some toxic assets but the psychology is what kept the Japanese economy at a bad equilibrium for the past 20 years.
  • Limited purpose banking is a simple and transparent system.

Kotlikoff concludes: “I am trying to save Main Street from Wall Street and Wall Street from Pennsylvania Avenue! I am trying to avoid huge government regulation that will surely have loopholes and that won’t create more transparency.  I am trying to implement a system where the taxpayers will not be responsible to save the companies that are supposedly managing risk”

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