Larry Kotlikoff Responds to Tyler Cowen

At the heart of the current financial crisis is a banking system in which credit institutions borrow short and lend long. They do this by putting depositors at risk, usually without their knowledge or consent. Federal deposit insurance makes this problem worse by giving depositors a false sense of security and encourages banks to make even more risky loans.

In a New Republic editorial last summer, Larry Kotlikoff and I proposed a new system in which all credit market firms — banks, near banks and even insurance companies — would essentially act like mutual funds. All deposits would be directly backed by the assets chosen by the depositor. Individuals could choose any degree of risk they like, but credit market institutions themselves would not take any risk. They would be pure intermediaries — connecting depositors with the assets they choose to back their deposits.

Larry has subsequently expanded the idea into a full-fledged book, which Tyler Cowen (once a believer in a similar approach, but now an apostate) criticized at Marginal Revolution. Larry responds to Tyler below the fold. I agree with him that Tyler doesn’t fully understand the proposal. You decide.

 (Note: Tyler’s critique is unbolded; Larry’s responses are bolded.)

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.

Tyler, it’s time to change your views again. You were right the first time around. 

First, there are plenty of reserves to back the cash mutual funds that would be part of Limited Purpose Banking. These would be the only mutual funds that are backed to the buck. Everything else would float and be risky in nominal terms. 

Second, real safety is not manufactured by government guarantees or by banks that rely on government guarantees. If you look at the millions upon millions of people who lost their jobs or large parts of their retirement savings through this crisis, you must agree that the current financial system is manufacturing, not mitigating risk. When the government guarantees things it can’t deliver, the taxpayer must make up the difference, so we get the risk through the back door.  That’s the case today with the FDIC. The government is backing, explicitly or implicitly, some $6 trillion with negative reserves. Were there a run on the bank tomorrow, Uncle Sam would need to print $6 trillion, prices would skyrocket, anyone who didn’t run would be left with worthless dollars, and you would be forced to acknowledge that the “safe, liquid assets” you reference aren’t really safe at all.  I and my co-authors have designed a system that isn’t subject to bank runs, period. That’s why it is ultimately much safer for the country than what we have.   

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…

I don’t follow this. We have 8,000 mutual funds in this country. Under Limited Purpose Banking we’d have more. Very few hold T-Bills. T-Bills may be held by the Tontine and Parimutuel insurance mutual funds I’m recommending, which let people safely bet on both idiosyncratic and aggregate risks, but the insurance pots can be held in other securities as well. Also, if the government borrows money and invests it, it’s not changing its net worth or, necessarily, it’s risk exposure, depending on the nature of assets purchased. 

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. 

You missed the key point that all incorporated financial intermediaries have to operate as mutual fund companies. There are no “non-bank commercial lenders” unless they operate as proprietorships and partnerships and their owners have their houses and yachts on the line. The risk of the banking sector is reduced because we set it up to eliminate any chance of bank runs and gambling by the banks with the taxpayers’ chips. Recall, the mutual funds are 100 percent equity financed at all times and in all situations. 

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 only financial intermediaries who can operate under Limited Purpose Banking according to the current rules of the road are private banks with no limited liability. The lack of limited liability will eliminate the moral hazard problem. 

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? 

I really hope you will re-read the book.  You are legitimately concerned about things that I would worry about if I had written the book you apparently skimmed.

Are General Motors, AIG, and GE Credit really the path to future financial sector safety? 

None of these entities can operate under Limited Purpose Banking in any way other than as safe mutual funds. I said repeatedly in the book that ALL (that means each and every) financial intermediary with limited liability must operate as a mutual fund, period. 

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.

Please consider what I am actually proposing and then decide what you think. I’m around to chat on the phone. Your concerns are good ones, but they apply to Dodd-Frank, not Limited Purpose Banking.

Comments (7)

Trackback URL | Comments RSS Feed

  1. Paul H. says:

    Saw your New Repulic article when it first came out and thought it was very reasonable.

  2. Tom H. says:

    As I recall the New Republic (liberal) commenters liked the proposal. But Larry also has a lot of right of center economists praising the book as well. This may be one of the few public policy proposals that aligns all parts of the ideological spectrum.

  3. Joe S. says:

    There have been other proposals for full reserve banking, including one by Milton Friedman. But I think this one is more carefully thought through — casting the net wide enough to capture near banks and even insurance companies.

  4. MorganS says:

    The key is that individuals can leverage as much as they prefer (or as much as investors will allow them). But credit market institutions cannot leverage or take on other risk. That means the insitutions which act as middle men in connecting savers and investors are not in danger of collapsing in response to changes in the economy or in financial markets.

  5. Dan M. says:

    If I recall, the idea was to deny credit market firms the the shield of limited liability. Normally, corporations get this legal special deal because we assume that but for transactions costs it is something that everyone would unanimously consent to anyway. But credit market intermediaries play such a special role that the assumption in their case is unwarranted.

    Without limited liabiilty protection, they cannot afford to take on risk. Hence they are forced into a warehousing function.

    I mention this only because the way you guys explain it, it sounds almost authoritarian. Whereas it really is consistent with a libertarian approach to the whole issue of money and credit.

  6. mkl says:

    Where you say

    “The only financial intermediaries who can operate under Limited Purpose Banking according to the current rules of the road are private banks with no limited liability.”

    you are referring to your proposed rules of the road, not the current state of affairs, no? There are still a number of surviving nonbank finance companies (GE Capital, CIT, the subprime auto lenders, etc.)

  7. Larry Kotlikoff says:

    MKL, When I say current rules of the road, I mean the current system. Under Limited Purpose Banking, GE Capital, CIT, subprime auto lenders and any other financial intermediary who wants to have limited liability must operate strictly as a mutual fund Please take a look at the book and let me know what you think. best, Larry