Review by Martin Sandbu
Jimmy Stewart is Dead
By Laurence Kotlikoff
Wiley ($27.95)
A reader of Jimmy Stewart is Dead could be forgiven for thinking that its author is an angry young man. The book describes the financial crisis in prose of populist wrath that would not be out of place in the “tea party” movement. It parades a procession of villains, from deposed Wall Street titans to Uncle Sam himself, and sends them packing in verbal tar and feathers.
In fact, the author is Laurence Kotlikoff, a Boston University professor whose research record extends to such rarefied topics as Ricardian non-equivalence in strategic altruism. But here his tone is more the agitator’s than the academic’s as he explains “in plain English and simple terms the big con underlying the big game”.
Hardly any part of finance escapes Kotlikoff’s whip. Executive compensation, subprime mortgages, derivatives, credit rating, bail-outs, even deposit insurance are so many forms of theft or snake oil, which only deliver so long as people believe they can. The basic problem, he says, is “multiple equilibria”: economies shift from growth to paralysis depending on whether consumers and investors expect things to hum along nicely or fear a collapse.
This is what almost kills the Bailey Building and Loan Association in It’s a Wonderful Life, the feelgood film starring James Stewart as an honest banker. Faced with a run on his bank, Stewart’s character educates shocked savers in the realities of fractional reserve banking: deposits are not held in a vault but recycled in loans to the community. If enough depositors worry about a bank’s safety, they cause the very failure they fear by demanding more than it has at hand.
Kotlikoff sees the current crisis as such a flip from good to bad expectations. In the film, Stewart regains the trust of the townspeople, who avert disaster by putting their money back in. But in our world, faith cannot be restored: Jimmy Stewart – or the kind of finance he represents – is dead.
If you cannot have trust, it helps to know that what you see is what you get. Kotlikoff has a simple and radical substitute for trust. “Limited purpose banking” would turn every financial product into a mutual fund and every limited-liability financial institution into a mutual fund provider.
Under LPB, mortgage lending, for example, would be done through “mortgage mutual funds” whose managers would pick loans to invest in. Mortgage applicants would provide the information they do today, and different funds could bid for their custom. The lenders would be investors owning shares in the mutual funds. At no point would any bank actually hold the mortgage on its books.
Indeed, banks would not hold anything on their books at all except the modest assets needed to manage a fund – computers and offices – and the matching equity. They would not be allowed to borrow and certainly not to trade with borrowed funds.
In LPB “cash mutual funds”, fully backed by cash, take the place of deposits. If this sounds like narrow banking, it is because it is – but LPB extends the principle to all of finance. Insurance and derivatives are replaced by funds issuing different shares, whose claims on the funds’ holdings depend on how specified events turn out. Crucially, this means all contingent liabilities are fully backed by capita!l.
Kotlikoff also wants independent custodians and a single agency verifying and publishing details on every investment: one would be able to look at each mortgage a fund holds before choosing to invest in it.
LPB would in one sense change a lot; in another, very little. Virtually every financial product in use today could be recreated as a mutual fund. But with all warts and blemishes exposed and no doubt that end-investors carry the losses, some would be priced out of existence. No bad thing with value destroyers presently masquerading as triple-A – but the worry is that LPB would take us from too much credit to too little.
“Financial life will be . . . smoother”, writes Kotlikoff, “because LPB will [reduce] the risk of fraud and systemic collapse.” Perhaps, but risks remain. It would be hard to stop non-financials from engaging in financial activities. Nor are mutual funds immune to runs: when a money market fund broke the buck in 2008, the US government rushed in with a backstop. But one big source of panic disappears under LPB. Banning leverage in financial intermediation makes it impossible for intermediation itself to collapse if a leveraged bubble bursts.
LPB may not be the answer, but it is a serious attempt to seek solutions at the required scale. Kotlikoff does us a great service by pointing out that only radical reform can fix finance. For that reason alone the ideas in this book deserve to be taken seriously.
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