Laurence Kotlikoff of Boston University is among the economics profession’s most creative thinkers. He was a key figure in developing “generational accounting,” which offers a quantitative — and horrifying — look at the fiscal burden we are leaving to future generations. He has come up with sweeping proposals for tax reform (emphasizing consumption taxes) and healthcare reform (emphasizing universal provision of vouchers). He also developed personal financial-planning software aimed at protecting one’s living standard in a country where fiscal and healthcare policies remain a mess.
Kotlikoff’s new book Jimmy Stewart Is Dead: Ending the World’s Financial Plague with Limited Purpose Banking offers an ambitious proposal to fix — or, more precisely, replace — our ailing financial system. The title refers to It’s a Wonderful Life, in which Stewart played a trustworthy small-town banker. Any resemblance the banking industry may once have had to that movie is long gone, as Kotlikoff points out, and the recent financial sector — with bankers taking on massive risks they neither disclose nor understand, then leaving taxpayers with the bill —is better described as “It’s a Horrible Mess.”
His solution is “limited purpose banking,” which would require banks to operate the way pass-through mutual fund companies already do: as middlemen. Banks (and insurance companies) would offer vehicles for investors and depositors but would not own any financial assets, let alone gamble with federally insured deposits. They would offer various mutual funds, including ones consisting of just cash or Treasury securities for safety-minded investors. Other mutual funds would be risky, but the risks would be borne by the customers. There would be no runs on banks, because banks would no longer be in the business of borrowing short and lending long. All they would do is collect fees (and investment banks would collect fees for advising on mergers and such, but also would not own any financial assets).
Kotlikoff would set up a single government agency, which he calls the Federal Financial Authority (FFA), to replace the financial regulatory functions now housed in some 115 federal and state agencies. The FFA would require and enforce accurate disclosure of a wide range of financial transactions. It would supervise the custody of financial instruments, so a latter-day Madoff cannot claim to hold securities that he does not. The agency would hire private rating companies to assess the risks of instruments, and would not allow those rating companies to engage in any conflict-of-interest financial relationships.
This proposal is hard to categorize ideologically (something true of much of Kotlikoff’s policy work). On one hand, it takes away the explicit and implicit federal guarantees of bailing out institutions and individuals who have taken on more financial risk than they can handle. On the other hand, it gives a centralized federal agency vast power in all areas of finance. (In an example Kotlikoff gives of how the FFA would work, the agency collects details of an individual mortgage borrower’s financial situation and places this info, minus identifying details, on a public website so the mortgage can be auctioned.)
Incidentally, Kotlikoff notes, limited purpose banking would give the government a more precise tool of monetary policy. The M1 measure of the money supply would exactly equal cash plus cash mutual funds (which would be fully backed by reserves), whereas today M1 depends partly on an uncertain relation between cash and checking account balances. Presumably, the Federal Reserve would be the agency implementing monetary policy under the new system (or at least Kotlikoff never states that the FFA would take over the Fed’s monetary authority, as opposed to its bank regulatory functions).
What to make of all this? Kotlikoff has presented a thought-provoking proposal that merits attention in the debate over financial regulation. He make a cogent point that a less radical effort to separate more and less risky areas of finance (such as the Obama administration’s push for the Volcker Rule, which would ban institutions that accept insured deposits from engaging in proprietary trading) is difficult to implement in a highly interconnected financial system.
At the same time, there is reason to be skeptical of Kotlikoff’s plan. There seems little basis for confidence that the powerful federal agency Kotlikoff proposes would not succumb to the flaws and temptations that regulators have shown in recent years, such as sleeping at the switch or being overly politicized. Having so much authority in the FFA would eliminate the ability of the regulated to shop around for a lenient agency, but it would also mean the FFA’s blunders would have wide effects.
It is both a virtue and a flaw of Kotlikoff’s approach that he essentially starts with a blank sheet of paper in drawing up a new financial system. We need bold thinking to deal with the current system’s deep problems, and Kotlikoff offers that. But one wonders not just whether such a radical proposal would work if implemented, but also what it would look like after going through the legislative meat-grinder.