Jimmy Stewart Is Dead: Ending the World's Ongoing Financial Plague with Limited Purpose Banking

By Laurence J. Kotlikoff

Discover how the global financial plague is poised to return, and what can be done to stop it

This is not your father's financial system. Jimmy Stewart, the trustworthy, honest banker in the movie, It's a Wonderful Life, is dead. And so is his small-town bank, Bailey Savings & Loan. Instead, we're watching It's a Horrible Mess with Wall Street (aka the Vegas Strip) playing ever larger craps with our economy and our tax dollars.

This book, written by one of the world's most respected economist, describes in lively, humorous, simple, but also deadly serious terms the big con underlying the big game?the web of interconnected financial, political, and regulatory malfeasance that culminated in financial meltdown and brought us to our economic knees. But it also proposes an amazingly simply solution?Limited Purpose Banking to make Wall Street safe for Main Street.

• This book, as well as the financial fix described within it, have received rave reviews from a veritable who's who of policymakers and economics, plus five economics Nobel Laureates
• Written by a leading economist whose insights on this topic are unparalleled
• Outlines the first and only proposal to fundamentally fix our financial disaster for good

Jimmy Stewart Is Dead will fundamentally change the way you think about the economy, financial markets, and the government.

• Language: English
• Publisher: Wiley
• Release date: Feb 18, 2010
• ISBN: 9780470609019

Laurence J. Kotlikoff

Laurence J. Kotlikoff is a professor of economics at Boston University and president of Economic Security Planning, Inc. His company websites are ESPlanner.com and MaximizeMySocialSecurity.com. To learn more, visit GetWhatsYours.org.

Book preview

001

Table of Contents

Praise

Title Page

Copyright Page

Dedication

Foreword

Preface

Acknowledgements

Chapter 1 - It’s a Horrible Mess

It’s Not Bailey Savings & Loan

Economics Diary, Spring 2009: The D Word

Economics Diary, August 22, 2009

The Treasury’s No-Stress Stress Test

Economics Diary, August 26, 2009: The State of the States

It’s the Psychology, Duh!

When Lexington, Massachusetts, Turns into Camden, New Jersey

Economics Diary, August 29, 2009: The Great D or the Great R?

Systemic Risk Insurance

Who’s Backstopping the Backstop?

Trust Doesn’t Come Cheap

Full Nondisclosure

A System with No Firewalls

Chapter 2 - The Big Con

Richard Fuld or Elmer Fudd?

Playing Bridge as Bear Burned

Macho, Macho Men

Stan the Man

Economic Diary, August 11, 2009: Uncle Sam Sues Uncle Sam

Economics Diary, September 14, 2009: Judge Rakoff to the SEC: Drop Dead

The Prince of Redness

CDOs to the Races

CDO Liquidity Puts

AIG’s Three-Hundred-Million-Dollar Man

Franklin Delano Raines

Speculation with Other People’s Money

It’s the Leveraging, Not the Leverage

Stealing Other People’s Money

Madoff’s Ponzi Scheme

The Essence of Ponzi Schemes

Economics’ Take on Ponzi Schemes

Don’t Show Me the Money

The Real Crime in a Ponzi Scheme

Is the U.S. Banking System a Ponzi Scheme?

From Ponzi Schemes to Full Disclosure

Disclosure Is Essential

Disclosure Is Not Enough

Uncle Sam’s Ponzi Scheme

Fiscal Gap Accounting

Why Is the U.S. Fiscal Gap So Large?

Social Security’s Unfunded Liability

Is the U.S. Bankrupt?

Chapter 3 - Uncle Sam’s Dangerous Medicine

Sam’s Got Your Back

Maturity Transformation in Theory and Practice

Backing the Buck

Opening Pandora’s Box

Economics Diary, September 14, 2009: Trade/Financial War with China?

Our Once and Future Horrible Mess

Big Brother, Can You Spare One Hundred Billion?

Bailing Out Corporate Pensions

Recapitalizing the Banks

Buying Up Toxic Assets

GASP—The Geithner and Summers Plan

Putting More of Someone Else’s Skin in the Game

Leverage upon Leverage

Weapons of Mass Financial Destruction

Proposed Control of Derivatives

The Dangers of Putting Wall Street on a Leash

Chapter 4 - This Sucker Could Go Down

Taking Stock

We Are Not All Keynesians Now

Reviewing the Case for Radical Surgery

Chapter 5 - Limited Purpose Banking

Full Disclosure—No Plan Is Perfect

Banks = Mutual Funds

The Federal Financial Authority

Ending Insider Rating

Bye-Bye, Bernie, Bye-Bye, Allen

Initiation, Not Securitization, Is the Problem

Securitizing Death

Cash Mutual Funds

Obviating FDIC Insurance and Capital Requirements

Cash Mutual Funds and Narrow Banking

Regaining Control of the Money Supply

Insurance Mutual Funds

Illustrating a Life Insurance Mutual Fund

Insuring the Uninsurable—A Life Insurance Example

The Financial Risk of Swine Flu

LPB Life Insurance Mutual Funds and Tontines

Illustrating Other Types of Insurance Mutual Funds

LPB Lets Us Leverage Us, But Not Our Countrymen

Using Insurance Mutual Funds to Buy and Sell CDSs

Sharing Aggregate Risk

Parimutuel Betting and Insurance Mutual Funds

Betting on More than One Horse/Mortality Rate

Illustrating a Homeowner’s Insurance Mutual Fund

Helping Solve the Corporate Governance Problem

Relationship of Limited Purpose Banking to Glass-Steagall

Isn’t LPB Simply Imposing 100 Percent Capital Requirements?

Chapter 6 - Getting from Here to There

Implementing Limited Purpose Banking

Zombies and Gazelles

Deleveraging Investment Banking and Trading

An End to Rogue Trading

The Politics of Limited Purpose Banking

Chapter 7 - What About?

Can We Just Agree to Agree?

Will LPB Reduce Liquidity?

Will LPB Reduce Credit?

Who Will Lend to Business?

Will LPB Reduce Leverage?

Will LPB Shrink the Financial Sector?

Doesn’t LPB Force Us to Become Our Own Bankers?

Isn’t LPB Reducing the Amount of Safe Assets?

Does LPB Require Homemade Insurance Policies?

Insuring Against Changes in Insurability

With LPB You Don’t Know the Odds Until It’s Too Late

Why Not Simply Correctly Price the Government’s Guarantees?

How Will Monetary Policy Operate?

What about Foreign Assets?

Won’t Americans Just Bank Abroad?

Doesn’t LPB Dramatically Shrink the Money Supply?

What’s the Role of the FFA in Investment Banking?

What about Venture Capital, Private Equity Firms, and Hedge Funds?

Is GE a Bank under LPB?

Can’t Nonfinancial Corporations Play Conventional Bank?

Why Let Proprietorships Run Traditional Banks?

Will LPB Prevent Financial Panics?

LPB Will Destroy Valuable Relationships and Information Banks Have About Their Borrowers

Economics Diary, November 11, 2009: Whither the Economy?

Chapter 8 - Conclusion

Afterword

Notes

About the Author

Index

Additional Praise for

Jimmy Stewart Is Dead

"The economic crisis has forced us to examine the shortcomings of our financial system. In Jimmy Stewart Is Dead, Laurence Kotlikoff argues that trust in the banking system has been broken and that only bold action will restore it. He calls for true transparency and offers thoughtful proposals such as Limited Purpose Banking to help restore trust in the system and to prevent such hardship from occurring again. Every Washington policy maker and public-spirited banker should read this book."

—BILL BRADLEY, former United States Senator

This book is scarier than anything Stephen King ever wrote, and just as well-written. Distinguished economist Larry Kotlikoff has started a new genre: nonfiction economic horror. Kotlikoff knows what happened and why, and has the courage to point fingers and name names. One cannot turn the final page without the sense that this book may be our country’s last hope.

—KEVIN HASSETT, Director of Economic Policy Studies; Senior Fellow, American Enterprise Institute; columnist, Bloomberg News

The only sure way to avoid another Wall Street meltdown and ensure financial institutions act in ways that serve the economy is to separate the utility function of banking, connecting savers to borrowers, from the investment function of the financial market casino. Laurence Kotlikoff ’s Limited Purpose Banking proposal is an important and timely step forward.

—ROBERT B. REICH, Professor of Public Policy, University of California, Berkeley; former U.S. Secretary of Labor

Larry Kotlikoff is that rare economist who comes up with the most original ideas when the stage is crowded with pedestrian analyses by other economists. He does it again with the current financial crisis. This is a marvelous book that will repay a careful read, even if you are as smart as Larry Summers and Ben Bernanke.

—JAGDISH BHAGWATI, University Professor of Economics and Law, Columbia University

This remarkable book from Larry Kotlikoff is an invaluable read for all of us who care about our country’s long-term competitiveness. I found it innovative, original thinking with a perspective of great value from a man to whom we should all pay attention.

—ADMIRAL WILLIAM OWENS, Chairman, AEA Holdings Asia; former Vice Chairman, Joint Chiefs of Staff

"If Michelin gave out stars to economists, Larry Kotlikoff would get three of them—worthy of a detour. Mixing villains, wit and wisdom, Jimmy Stewart Is Dead is a great read with a serious message. Kotlikoff makes a compelling case for regulation that would restructure the banking system to limit banks to their basic functions, and he shows how doing so would allow market forces to make the next financial crisis less likely and less severe. This is a desperately needed antidote to the spate of proposed reforms from the usual pundits that amount to nothing more inspired than a call for more regulation without a recipe for smarter regulation. Iconoclastic but practical, Kotlikoff is one of the most creative economists of his generation and one of its premier policy analysts. It would be folly not to listen to him."

—STEPHEN A. ROSS, Franco Modigliani Professor of Financial Economics, MIT

"Informative, infuriating, and insightful. If you think you understand

the extent of the malfeasance by Wall Street and by our Federal Government,

you are in for a rude shock when you read this book. Larry

Kotlikoff understands the scope of the problems we face better than

any economist I know; he uses clear, accessible and lively prose; best

of all, he offers an innovative and provocative solution to this gargantuan

problem. Send copies of this book to your representatives in

Washington!"

—EDWARD E. LEAMER, Chauncey J. Medberry Professor of

Management; Professor of Economics and Professor of Statistics,

University of California, Los Angeles

This is provocative and hard-hitting analysis. A leading academic economist takes off the gloves and goes a hard eight rounds with financeas-we-know-it. The result is a fresh and clear proposal for reducing the risks that arise as people with savings provide funding to people making productive investments in any economy. If we implement Professor Kotlikoff’s ideas—or any close approximation—the U.S. can continue to generate entrepreneurship, growth, and jobs, without repeatedly having to bail out our big banks. This is beyond appealing; it is compelling.

—SIMON JOHNSON, Professor of Entrepreneurship, MIT Sloan; former Chief Economist, International Monetary Fund

Larry Kotlikoff has been consistently ahead of the curve in the debate on America’s coming fiscal breakdown. Now he turns his attention to the financial crisis that threatens to bring that fiscal breakdown forward to, well, quite possibly this year. I was wholly persuaded by the case he makes for Limited Purpose Banking. It is clearly the best available remedy for the present appalling state of affairs, in which highly leveraged ‘too big to fail’ institutions can expect taxpayers to pick up the multi-trillion-dollar tab when their gambles go wrong.

—NIALL FERGUSON, William Ziegler Professor of Business Administration, Harvard Business School; author, The Ascent of Money

Kotlikoff provides a marvelously clear explanation of how today’s financial system really works, stripping away all the obscure jargon. At the same time, the book is a passionate and strongly worded indictment of the system and a blueprint for how to fix it from the ground up. Kotlikoff ’s basic thesis: that today’s financial institutions have become taxpayer subsidized casinos increasingly divorced from the basic intermediation activities society expects them to perform—is hard to refute.

—KENNETH ROGOFF, Thomas D. Cabot Professor of Public Policy and Professor of Economics, Harvard University; former Chief Economist, International Monetary Fund; co-author, This Time Is Different

"I always make time in my busy schedule to read anything Larry

Kotlikoff writes. You should too. Why? He is always insightful in his

analysis, provocative in his predictions, and creative in his proposed

solutions. In Jimmy Stewart Is Dead, Kotlikoff lays open the fundamental

fissures in the financial system and presents a radical solution: Limited

Purpose Banking, an idea related to proposals during the Great

Depression by renowned American economists Frank Knight and Irving

Fisher. When I was helping clean up the last American financial crises—

the Savings and Loans mess and the Latin American debt fiasco for

the big money center banks—I lamented the dearth of creative policy

thinking before they struck. Policymakers, investors, taxpayers, and all

concerned citizens will find much to mull over in this readily accessible

book."

—MICHAEL J. BOSKIN, T.M. Friedman Professor of Economics and

Senior Fellow, Hoover Institution, Stanford University; former

Chairman, President’s Council of Economic Advisors, 1989-1993

"Laurence Kotlikoff is one of the original thinkers of our time. Even if you don’t agree with his specific proposals, Larry’s new book—with the provocative title, Jimmy Stewart Is Dead—is likely to lead you beyond the conventional ways of dealing with the economic challenges facing our country."

—MURRAY WEIDENBAUM, Edward Mallinckrodt Distinguished

University Professor and Professor of Economics, Washington

University, St. Louis; former Chairman, President’s Council

of Economic Advisers

This book is heaps of fun. But it is entirely serious, and comes at the right time. The profound change—Limited Purpose Banking, which Kotlikoff recommends and that we desperately need—could only be undertaken now that we’ve seen the full dangers of maintaining the current financial system. Kotlikoff entertains with great energy while instructing using facts made for fiction. To understand the most effective changes we can make to truly fix our financial system, read this book.

—SUSAN WOODWARD, Principal, Sand Hill Econometrics; former Chief Economist of the U.S. Securities and Exchange Commission; former Chief Economist of the U.S. Department of Housing and Urban Development

Our financial system puts us all at risk. This book shows that it doesn’t have to be this way. We can have all the benefits of a modern economy without having crises like the last one. Or, if policy makers don’t listen, like the next one. And the next . . .

—PAUL ROMER, Senior Fellow at Stanford Center for International

Development (SCID) and Stanford Institute for Economic Policy

Research (SIEPR), Stanford University

This book grips like a novel. But, it’s no work of fiction. It’s our actual financial horror story in which we face ongoing economic torture at the hands of greedy bankers, incompetent regulators, and corrupt politicians. The book is a penetrating and painless (indeed, fun) education as well as a saving grace. It offers the only clear path to economic salvation—forcing banks to do the one and only thing they are here for—financial intermediation.

—CHRISTOPHE CHAMLEY, Professor of Economics, Boston University

"If the Crash caused you to fear for your job, your retirement, and for

the future of your children, read this book. You will be led by one of

America’s most eminent economists through a blow-by-blow account

of what happened and why, and there will be times you will feel like

running to the window to shout out your outrage and call for change.

Kotlikoff ’s proposal for Limited Purpose Banking calls for the most

radical overhaul of banking legislation since the Great Depression."

—URI DADUSH, Senior Associate and Director of International

Economics, Carnegie Endowment for International Peace;

former Director of International Trade and

Director of Economic Policy, World Bank

Forget narrow banking concepts. Professor Kotlikoff forces us to consider Limited Purpose finance, and does so with humor and enlightenment.

—ROBERT R. BENCH, Senior Fellow at Boston University School of Law; former Deputy U.S. Comptroller of Currency

Larry Kotlikoff has written a fascinating book. It is a must read for everyone who wants to understand the current financial crisis and what we can do about it.

—JOHN C. GOODMAN, President and CEO, National Center for Policy Analysis

"Larry Kotlikoff has written a provocative, entertaining, and well-written book, analyzing how our financial crisis arose and how to fix it permanently. In some ways the last 20 years seem like a return to the 1800s, with financial instability driving the business cycle. Professor Kotlikoff tells us why and how to fix it. Anyone interested in finance, options, long-term contracting, banking, and financial and macroeconomic policy must read this book, and it is a good read for the individual investor as well. His Limited Purpose Banking financial fix is critically important to our future prosperity."

—R. PRESTON MCAFEE, Vice President and Research Fellow,

Yahoo! Research; former J. Stanley Johnson Professor of

Business Economics and Management,

California Institute of Technology

This is an entertaining romp that explains our recent not-so-entertaining financial calamity. Whether or not you agree with Kotlikoff’s policy prescription, you must admit that it’s provocative.

—RUDOLPH G. PENNER, Institute Fellow, Urban Institute; former Director of the Congressional Budget Office

Kotlikoff lays bare the fault lines of traditional banking and makes a compelling case why ‘Limited Purpose Banking’ should be part of the reform discussion.

—PROFESSOR CORNELIUS HURLEY, Director of the Morin Center for Banking and Financial Law at Boston University; former Assistant General Counsel to the Federal Reserve Board

Kotlikoff is a distinguished scholar with a passion for addressing the big issues. His previous books for the general public dealt with tax reform, Social Security, health care, federal deficits, and intergenerational equity. In each case he demonstrates analytical clarity, political independence, and a lively and entertaining writing style. Now he has turned his attention to the financial crisis and once again offers fresh insights and sensible proposals. I recommend this book to independent thinkers of good conscience, no matter what their political affiliation.

—ZVI BODIE, Norman and Adele Barron Professor of Management, Boston University

Kotlikoff makes a strong case for Limited Purpose Banking as the best protection against the next financial crisis. I worry most about his proposal for replacing all current federal and state financial regulatory agencies with one massive federal financial authority; this authority, I suggest, would increase the scope of regulatory mistakes and the prospect and capability of the federal government to allocate credit for political objectives. I encourage readers of this book to make your own judgment about the regulatory environment that would best complement Limited Purpose Banking.

—WILLIAM A. NISKANEN, Chairman Emeritus of the Cato Institute; former Acting Chairman and Member of the President’s Council of Economic Advisers

This is a must read for everyone who wants to know not only what went wrong, but how to fix it. Kotlikoff has brilliant answers to the most important questions in economics today.

—ANNA BERNASEK, economic journalist and author of The Economics of Integrity

Laurence Kotlikoff has produced an entertaining and insightful analysis of the great credit crisis and the ailments of the U.S. financial system. This sets the stage for some radical proposals to change the structure of the financial intermediation. In his view triage is not enough—what is required is radical reconstructive surgery. Whether you view his recommendations for Limited Purpose Banking as politically viable or not, his analysis goes to the heart of the important flaws that have to be confronted if we are to reduce the likelihood of crises in the future. This book is essential reading for those interested in the perils of financial intermediation in the modern world.

—THOMAS F. COOLEY, Dean and Paganelli-Bull Professor of Economics, New York University Stern School of Business

Kotlikoff understands markets and market makers. And he understands economics. He vividly diagnoses the financial plague, and he argues that, as is, the system is unsafe at any speed. His remarkably simple cure does not rely on a dying breed—honest bankers like Jimmy Stewart (a.k.a. George Bailey), but on limiting banking to its only honest purpose—financial intermediation.

—HERAKLES POLEMARCHAKIS, Professor of Economics, University of Warwick

Larry Kotlikoff provides a poignant, accessible, and engaging account of how distorted incentives, leverage, and risk played a major role in the financial crisis. He also confronts us with a scary account of the government deficits that will come to haunt us or our descendants. Kotlikoff ’s ideas for how to change the banking system are thought-provoking. This book forces us to step back and think about the basic purpose of financial institutions, and whether there is a better way to organize them.

—ANAT ADMATI, George C.G. Parker Professor of Finance and Economics, Graduate School of Business, Stanford University

Many doubt whether proposed regulatory reforms regarding capital requirements will be effective in reducing the excessive risks taken by banks and other financial institutions. Larry Kotlikoff offers a more fundamental solution called Limited Purpose Banking (LPB), in which banks connect borrowers to lenders and savers to investors without taking on risk. This radical idea, challenging the existing structure of all financial institutions, deserves to be at the center of the post-crisis debate. Economists and practitioners alike will find this a compelling book.

—EYTAN SHESHINSKI, Sir Isaac Wolfson Professor of Public Finance, Department of Economics, The Hebrew University

001

Copyright © 2010 by Laurence J. Kotlikoff. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Kotlikoff, Laurence J.

Jimmy Stewart is dead : ending the world’s ongoing financial plague with limited purpose banking / Laurence J. Kotlikoff.

p. cm.

Includes index.

eISBN : 978-0-470-60901-9

1. Fiscal policy—United States. 2. Financial crises—United States—History—21st century. I. Title.

HJ2051.K663 2010

332.0973-dc22 2009041432

For Miguel, the bravest man I know!

Foreword

by Jeffrey Sachs

Larry Kotlikoff is a worried man on an urgent mission. He knows that the financial crisis that hit us in 2008 can come back with a vengeance, because our government, so far, is treating the symptoms but not the underlying disease. By the time you finish this book you will be worried too. With brilliance, wit, clarity, and bravery, Kotlikoff explains how our financial system is virtually designed for hucksters. Yet even more importantly, he shows us how to fix it.

As Kotlikoff makes clear, the litany of faulty incentives and opportunities for fraud in the U.S.’s banking system is distressingly long: limited liability, fractional reserves, off-balance-sheet bookkeeping, insider-rating, kick-back accounting, sales-driven bonuses, nondisclosure, director sweetheart deals, pension benefit guarantees, and government bailouts. It’s a system, in a word, in which bankers make promises they can’t keep in order to collect outsized earnings unrelated to real productivity.

What a cast of characters we will meet along the way! Kotlikoff is right to note that most bankers are fine people doing their best by their clients, but he is also right on the mark to note that the top ranks of bankers include a remarkably large number of fast-talking con artists, riverboat gamblers, and highway men. And why not? With regulatory loopholes a mile wide, the con artists found ways to abscond with tens, even hundreds of billions of dollars, before the entire economy went over the cliff.

I’ve taken my own special interest in the bankers’ bonuses over the years, as I’ve witnessed up close how rather pedestrian Wall Street work on restructuring developing country debt could pull in millions of dollars in fees for the bankers. At the start of each calendar year, I’ve gone slack-jawed at a level of Wall Street year-end bonuses roughly equal to the total worldwide aid given to 800 million Africans.

At a recent dinner with bank executives to discuss African poverty, I surmised the depth of their concern with this heartbreaking issue as they steered the conversation to the relative size of their wine cellars, with several describing their collections as exceeding 30,000 bottles! The typical African could spend his whole life working and never afford a single one of those bottles.

These are signs not merely of moral decadence but of regulatory collapse. Kotlikoff skillfully leads us through the various methods that the banking leaders have developed for taking their slice of the assets. Amazingly, none of the executives who we meet in these pages was technically equipped to understand the deeper risks in which they were placing their firms, and the world economy. But they were very well trained in cutting themselves extremely generous proportions of the action.

If Kotlikoff had stopped at explaining what just hit us, he would have performed a mighty service. Even with the many vivid and entertaining accounts of the great crash in 2008, of who said what to whom on the fateful weekend in September 2008 when Lehman, AIG, and Merrill hit the wall, no previous book comes remotely close to this one in offering a conceptual understanding of what has gone wrong. Through ingenious examples and stories, Kotlikoff gently instructs the readers in the core concepts of financial economics: coordination failures, moral hazard, intergenerational accounting, principal-agent problems, Ponzi schemes, and much more.

It is our great fortune, though, that Kotlikoff does not stop there, but proceeds boldly to lay out a novel, powerful, and ingenious set of reforms under the rubric of Limited Purpose Banking. As he explains, the motivation of LPB is to "limit banks to their legitimate purpose—connecting borrowers to lenders and savers to investors—and not let them gamble. But Kotlikoff is no scold. He’s not against gambling per se. He’s only against others gambling with our money without our knowledge or permission.

This is the protection of LPB. If individuals want a completely safe bank account, their bank deposits will be matched 100 percent by money held by the bank. If they want something riskier, or some form of insurance, then appropriate mutual funds will be available to cater to distinct needs, and set up in ways to avoid systemic risk. In all cases, financial intermediaries will face not 115 different regulatory agencies asleep at the wheel, but a single Federal Financial Authority with a very limited assignment—to ensure that fund managers do not abscond with our assets and immediately, fully, and accurately disclose what each fund is holding. Imagine that—a financial marketplace in which we’re actually told what we’re buying!

Kotlikoff traces some of the origins of his ideas to proposals for Limited Banking that emerged in the wake of the Great Depression, and which have won the endorsement of leading economists over the decades. He does not shrink from pointing out continued controversies surrounding his ideas, so that the book provides an ideal jumping off point for further serious debate over the ideas.

There are lots of open questions and areas of doubt that require further discussion, notably around the issues of how fast, how far, and in what ways we would need to adopt LPB to reap its benefits.