Jimmy Stewart is Dead
Forward 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 America’s banking system is distressingly long: “limited liability, fractional reserves, off-balance-sheet bookkeeping, insider-rating, kickback accounting, sales-driven bonuses, non-disclosure, 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 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 remarkably simply reforms under the rubric of Limited Purpose Banking (LPB). As he explains, the motivation of LPB is to “limit banks to their legitimate purpose – connecting borrowers to lenders and savers to investors – and don’t 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 market place 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. Still, the ideas are powerfully resonant and will find a growing group of adherents.
America is passing through a very difficult economic juncture, with high unemployment and even higher anxieties. Millions of people have seen their financial security lost in the Wall Street tsunami. We feel adrift, with a large majority sensing, correctly, that the country is headed in the wrong direction. Faith in the economic system, the lifeblood of the economy itself, has been badly broken. Kotlikoff knows that each of us bears a responsibility and has a role to play to help repair the damage. With characteristic directness and integrity, he says that every economist has “an obligation . . . to focus on this economic emergency.” Let us thank Kotlikoff for a clear, convincing, and highly original call to action. With this book, he has surely fulfilled his obligation, and much more, to help the world reset its sights on a more stable, fair, and prosperous economy.
Jeffrey D. Sachs is Director of The Earth Institute, Quetelet Professor of Sustainable Development, and Professor of Health Policy and Management at Columbia University