*Jimmy Stewart is dead*

So says Larry Kotlikoff, in his new book, entitled Jimmy Stewart is Dead: Ending the World's Ongoing Financial Plague with Limited Purpose Banking.  It's lively and polemic, and suddenly it lurches into a proposal to reform financial intermediation:

Under limited purposes banking the banks are themselves simply financial intermediaries, while their mutual funds represents mini-banks, if you like, all of which are subject to 100 percent capital requirements.

Explained another way, you hold liquid securities directly and cut out the middleman of the lending bank.  It's like expanding the idea of a checkable money market mutual fund to cover the retail banking sector.  Here is his short Op-Ed on the idea, here is a Business Week article, and here are numerous endorsements for the book.  See also Bob Litan on "narrow banking." 

I used to advocate a version of this idea myself, but I no longer think it is a good reform proposal, for a few reasons: 

1. There aren't enough safe, liquid assets to cover the stock of bank deposits.  There would be even fewer safe, liquid assets if fiscal conservatives had their way.  And we've now learned that the commercial paper market can seize up and shut down and AAA securities aren't always so safe.

2. Holding T-Bills eliminates the need for the bank intermediary and the resulting problems of moral hazard.  But remember — these ends are achieved only by lending that money to the government.  What's the old saying?: out of the frying pan, into the fire…

3. A lot of what current banks do would be replicated by non-bank commercial lenders and the risk of the banking sector would be transferred somewhere else.  Ideally, these non-bank lenders would engage in greater "maturity-matching," but if banks will exploit the moral hazard problem won't these lenders exploit it too?  The financial crisis very much changed my mind on this question.  Can't such lenders, to policymakers, appear "too big to fail" in the same way that standard banks do?  Are General Motors, AIG, and GE Credit really the path to future financial sector safety?  Maybe there is room for improvement, by using more commercial lending, but it is murky and I no longer see a clear gain in this regard.

Here, by the way, is a Bert Ely critique.


I think it represents a sign of intelligence and maturity to critique one of your old proposals and now reject it.

This is so unacademic.

Your criticisms are correct, Tyler. After the Reserve Primary Fund broke the buck and the Treasury announced the Temporary Guaranty Program for Money Market Funds, it became clear that these funds have 0% capital rather than 100% capital.

There would be even fewer safe, liquid assets if fiscal conservatives had their way

How sure are of this assertion are you? Greece's debt used to be safe and liquid, but it wasn't fiscal conservatism that changed that perception. It seems to me that you can have more and more "safe and liquid" assets for a shorter period of time, or you can have less for a longer period of time, but you can't have both.

However, I don't disagree with the last criticism about how shadow banking will simply reemerge elsewhere and have it's risks eventually taken onto public balance sheets. The problem is political, however, not financial. Indeed, the present banking system wouldn't be threatening the entire economic system if we hadn't been trying to eliminate failures and losses for the last 70 years. Kotlikoff's solution isn't a solution in the sense that it doesn't directly address the real problem (though it is trying an indirect approach), which is the moral hazard created by the political system's guarantees against financial risk. I am slowly coming to the conclusion that there is no solution to this problem- we are simply going to have to live with recurrent collapses of economic systems/civilizations followed by rebirth/regrowth. It probably is just a part of the nature of what we are as a species.

Devin Finbart,
I agree with all your points. In particular, we should always emphasize that many of the problems are caused by inept and corrupt governments, and the priority should be to reform these governments. And to strengthen your last point, Tyler and his readers should always remember Jon Danielsson's corollary to Goodhart's law: a risk model breaks down when it is used for regulatory purpose.

Kotlikoff wants to do several things. He wants complete transparency in the financial sector, and proposes a new government agency, the Federal Financial Authority, that would provide information and transparency. It would replace over 100 regulatory agencies. I find this proposal implausible. He wants to get rid of fractional reserve banking, which has largely been accomplished, at least for the present. The purpose of his limited purpose banking is to move risk-taking from the financial institutions to individuals. People would not be happy with this, but it is happening in pension plans. The decline of the defined-benefit pension plans and the rise of the defined-contribution plans is a step in this direction, but the push for that has come from companies, not individuals. Anyone wanting to take the kind of gambles or engage in the amount of leverage that are commonplace in the financial institutions could still do so, but they would face unlimited liability. I think that idea is worth further discussion.

His best sentence: "This entire financial crisis has been a case study in moral hazard with self-declared financial gurus placing the bets, while bearing essentially none of the risks. (p. 91)

He has some kind words for Ponzi-schemes and points out that the government's inter-generational transfers are a Ponzi scheme. One thought his book prompted was that a solution in the future to the social security deficit may be to make it like his mutual funds that would be behind bank deposits--the money paid out could not exceed the payments into the system.

It is a fun book, with the first part being the better half.

Limited Purpose Banking has the whiff of "assuming a can opener." Many macroeconomists write about banks as mere money supply pumps utilizing a dangerous fractional reserve mechanism. So let's try to act like microeconomists and really understand the real sector value that bankers provide.

The banking system is a giantic initial public offering (IPO) generator that dwarfs whatever IPOs are generated by Wall Street. It contrasts with mutual funds that are parasites upon the pricing activities performed in secondary markets like NASDAQ, NYSE, etc. Bankers originate opportunities using sales people in branches. They perform a credit analysis of the loan and accept or reject the borrower. Then they monitor the loan for compliance with covenants, especially in the cases of commercial loans for working capital lines of credit that no mutual fund could ever service. They collect payments due and distribute moneys to depositors and bank share holders. These are expensive and labor intensive activities.

Now tell me who is going to maintain a secondary market pricing the $1 million revolving line of credit for a small business with $10 million in annual revenue and 45 employees? Or the $3 million commercial property loan to the owner of this business?

Does Kotlikoff believe that all the regulations of the SEC applied to firms that want to go public can be dispensed with to make it cost effective for these small businesses to be properly transparent for the market? Most businesses borrowing less than $5 million a year don't even have CPA audits performed. Would he propose forcing this expense upon a huge swath of America's business owners?

The alternative to bankers is not an open-end mutual fund of loans to small business owners and home buyers that offers to redeem shares on a daily basis, marked to market. The alternative is similar to what we see in private equity firms where investors are usually unable to retrieve their initial investments for several years until the loans or shares of non-publicly traded companies start generating sufficient income to distribute payments. Is that structure going to attract the savings of a 2-child couple with household income of $90,000/yr? Today these equity funds attract pension funds, insurance companies, and wealthy investors who are situated to wait for these returns and not demand daily liquidity.

Bankers exist because, unlike private equity firms, they offer daily liquidity on the portfolio of debt IPOs they originate every single day. For various reasons, these borrowers cannot and do not go "public" with their debt. The main reason is that there is a high fixed cost hurdle of going public and then ongoing costs of maintaining transparency on an ongoing basis to facility secondary market pricing and trading.

Fractional reserve banking exists, not because some macroeconomist said to banks "go make money," but because depositors said to bankers, "I'll take a much lower yield on my investments with you if you promise to offer me daily liquidity."

Abolishing fractional reserve banking would be a disaster for our economy. In fact, the Great Depression was prolonged largely because depositors were wary of banks for several years and so the IPO engine of our nation shut down.

Our current recession came as a result of a failure of secondary markets to properly price the real estate loans generated by bankers, not a collapse of fractional reserve banking we saw in 1929. Because bankers didn't have any skin in the game, they could afford to be careless in their underwriting and let the suckers owning collateralized mortgage obligations, Fannie Mae, and the taxpayers pick up the tab.

The logical and more efficient path for Kotlikoff to travel is not Limited Purpose Banking, but urging the Federal Reserve to allow individuals and businesses to open up accounts at the Fed. Those accounts would be perfectly safe and no regulations would be required.

Here is a link to the New Republic article written by Larry Kotlikoff and John Goodman on limited purpose banking. http://www.ncpa.org/pdfs/newrepub_JCG_kottli51809.pdf

Kotlikoff claims that limited purpose banking would allow the Fed to more tightly control the money supply, whereas today the Fed appears to have less and less control of the money supply, because of the rise of nonbank financial institutions and nondemand-deposit instruments. These alternative money markets are accomplishing, to an extent, what free banking advocates (those who would eliminate central banking) would allow: Letting banks (and other financial institutions) issue their own notes -- ie, create near-money substitutes. It is not evident to me that limited purpose banks would put an end to that process (or that we should want to stop the process) or that limited purpose banking would give the Fed any more control of monetary system than it has -- or that if it did give the Fed greater control, that would be desirable.

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