Whatever We're Doing, It's Not Working

Economist says our system is broken and Washington doesn't have a clue how to fix it.

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In his latest book, "Jimmy Stewart Is Dead," Boston University economist Laurence Kotlikoff says the fundamental soundness of our financial system is so compromised that nothing short of revolutionary fixes will save this patient, and set our economy on a healthier trajectory. Harking back to Jimmy Stewart's movie role as small-town banker George Bailey in "It's a Wonderful Life," Kotlikoff says the era of responsible banking has been replaced by the highly leveraged and morally bankrupt system whose crash brought on the worst downturn since the Great Depression.

[See Best Affordable Places to Retire.] Remember the classic science experiment? A frog immersed in warm water will adjust so well as the temperature is gradually increased that it will allow itself to be cooked alive without jumping out of the water. Well, Kotlikoff says, we are the frogs in a financial experiment that's gone terribly wrong:

Jimmy Stewart, the honest, warm, kind, and trusting soul is not your local banker. Jimmy Stewart is dead. Your local banker is some underpaid clerk who's been in place for six months and knows nothing about you, your family, or your business, and frankly could care less. His job is not to apply personal knowledge in deciding to lend you money or call your loan. His task is to plug your credit rating, income, loan request, appraisals, and other data into a computer and tell you what the computer tells him, namely how much you can borrow and at what rate.

Our bankers are desperately attached to the current system for good reason. It lets them socialize risks and privatize profits. Socializing risk means having the public take the hit when things go south. Privatizing profits means earning big fees in normal times. These thoughts are not original. But Kotlikoff (disclosure: I know Larry and have written about him before) provides a particularly chilling review of the problems that brought on the crash and how they are part of a larger series of calamitous economic trends. Washington, in his view, may well be the last place we should look for a solution. Its policies enabled and encouraged the reckless behavior of our financial institutions. Its proposed remedies fall far short of solving our problems. And there has been little progress in the past 18 months in enacting even these limited cures. "Nothing short of economic open-heart surgery will save the American dream," he writes.

If the Tea Party folks haven't discovered this book, they should. Larry says what's on his mind, is not particularly concerned with making friends in government or business, and has solid credentials to back up his conclusions. In reviewing our meltdown, he doesn't spare himself or his colleagues from criticism, either. "With rare exceptions, those of us manning the watch -- the economists hired by the government and the business world -- missed what was coming, were shocked when it happened, exacerbated the public's fear, and are now helping resurrect the system that failed so miserably."

[See Best Places to Retire.]

Such behavior, Kotlikoff says, is part of a broader pattern of financial malfeasance. The federal government is able to print money and spend its way out of jams. Unable to resist the allure of the next election, our leaders have literally promised Americans they will spend upwards of $80 trillion on future benefits that the government simply has no way of obtaining. Short of hyper-inflating the money supply with devalued currency, we will not meet those promises. We are, in Kotlikoff's less than humble opinion, bankrupt. Yet our leaders find it easier to look the other way or engage in political brinkmanship than get down to work.

Looking the other way also explains why financial firms were allowed to become too big to fail and put our money at risk and not theirs. They adopted and then over-dosed on highly leveraged financial instruments. These securities are still not fully understood by even sophisticated financial experts, and certainly not by the politicians who are supposed to fashion remedies. While tougher regulations are being sought in Washington, Kotlikoff notes that there are roughly 115 financial regulatory agencies already. The problem is not that banking is under-regulated; it's that the regulators looked the other way instead of doing their jobs.

Kotlikoff's antidote to what ails us would be very bitter medicine for financial firms to swallow. First, he wants to forbid them from putting our money at risk. Second, he wants to replace those 115 regulators with a single agency. Its major job would not be just to police the banks but to become, in effect, the information marketplace and traffic cop for a new kind of banking that he calls limited purpose banking.

In this system, banks wouldn't be able to take any risks themselves, so they could never put depositor or taxpayer money at risk. Every business transaction involving a financial firm would be treated as if it were a mutual-fund holding. For example. if you wanted to borrow money to buy a home, your demand for loan funds would be matched up with an investor interested in buying your loan on mutually known and acceptable terms. The bank would receive some fees as an intermediary but the home loan would never be on its books.

By settling up special mutual funds for all sorts of economic activities, borrowers and lender-investors could be brought together for literally any reason. Kotlikoff's single regulator would make sure borrowers and investors met certain standards. Transparency would be king in his world. Nothing would limit people from taking extraordinary risks, which Kotlikoff recognizes come with the territory in a market-based economy. But under limited purpose banking, those risks would never sit on a bank's books and thus would never come back to bite the public in the form of bailing out a failed institution. Even your bank deposits would be placed in such a fund. And because deposits would be fully backed, dollar for dollar, we would no longer need deposit insurance.

"Jimmy Stewart Is Dead" makes for provocative reading. We certainly have squandered much of America's business and economic strength in the pursuit of personal gain and huge if not obscene bonuses. Yet the odds of such a system reset as limited purpose banking are slim. One can only shudder at how much worse things would have to become to consider such extreme changes. It might just be easier to find another Jimmy Stewart. I'd call him Mr. Smith. And I'd ask him to go to Washington.

[See It's Time to Review Retirement Path.]