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Home > Blogs > Ian Fraser > World on brink: As central bankers run out of ammo, the need for alternative models has never been more urgent

World on brink: As central bankers run out of ammo, the need for alternative models has never been more urgent

Kotlikoff | World on brink: As central bankers run out of ammo, the need for alternative models has never been more urgent Ian Fraser

The Bank of England governor Sir Mervyn King yesterday added to the general sense of doom that has pervaded financial markets by saying "This is the most serious financial crisis we've seen at least since the 1930s, if not ever."

King didn't catch the financial markets unawares. Ever since the Greek crisis erupted March 2010 most market participants have sensed the deepening cracks in the global economy, and been disappointed by the politicians' singular inability to resolve it. However, King did take bankers by surprise on October 25, 2010, when, in a wide-ranging speech on how to reform the financial sector given to the Buttonwood gathering in New York, he said: “Of all the many ways of organising banking, the worst is the one we have today.”

King added:

"Many remedies for reducing the riskiness of our financial system have been proposed, ranging from higher capital requirements on banks to functional separation and other more radical ideas. The guiding principle of any change should be to ensure that the costs of maturity transformation – the costs of periodic financial crises – fall on those who enjoy the benefits of maturity transformation – the reduced cost of financial intermediation. All proposals should be evaluated by this simple criterion."

Those who could read through the deliberately opaque central-banker-speak sensed something remarkable here. The governor of a central bank is not normally expected to say such things. The City bigwigs were incensed. After all, wasn't King supposed to the cheerleader for the London-based financial sector? Among the most disappointed was The Economist. In a rather snide piece titled 'King plays God', the free-markets-loving magazine gave King a bit of a kicking.

The magazine claimed it was strange that an institution that had ignored finance for a decade should now want to reinvent it. It alleged that the "Old Lady of Threadneedle Street" was internally divided and, citing anonymous senior banking sources, derided King for being "middle class" and talking above his pay grade. The Economist's article said:

"...even foreign financiers with little business in Britain are amazed that the governor of the Bank of England does not seem to want any of the large banks he is charged with regulating to exist."

It's a revealing comment and is probably not too far from the truth. Professor Laurence Kotlikoff of Boston University was none too impressed by The Economist's narrow-minded counter attack and, in a follow up piece in the same publication, the US economist stood up for King.

Kotlikoff, who is the author of Jimmy Stewart Is Dead and a supporter of so-called Limited Purpose Banking, argued that King was in fact a rare voice of sanity in an increasingly dysfunctional financial world. Kotlikoff also stated that he hoped that King's speech might persuade those who are fighting reform on the very edge of a precipice (I think he meant people like RBS chief executive Stephen Hester and Barclays boss Bob Diamond) to take a step back from the edge to reconsider their blind enthusiasm for a fundamentally flawed model of capitalism.

Enlarging on the theme that I explored in an earlier blog post ('Kotlikoff: financial system is a Ponzi scheme that could collapse at any time'), Kotlikoff  said he wholeheartedly agreed with King's view that the banking system, as it is currently structured, is the "worst possible". As I said in the earlier piece, this is because financial institutions insure the uninsurable and take on liabilities they cannot honor, while these institutions and their managers take on only limited liability and pass the buck to the taxpayer when things go pear-shaped. Kotlikoff said the system is flawed and will fail because it is "built on two pillars of straw—proprietary information and leverage." Kotlikoff added:

"The banks are here to intermediate—to connect lenders to borrowers and savers to investors. They are not here to borrow on their own account, make risky investments, hide the details of those investments, and then arrange for taxpayers to cover their losses when their gambles turn sour.

"This system is not only a foundation for systemic fraud, it's a prescription for financial collapse. Since those who lend to the banks, via deposits or the purchase of bank paper, aren't privy to what is being done with their money, the strong whiff of fraud, whether actual or not, can provoke massive bank runs. What we saw in 2008 was precisely this—a fraud run. It was not a liquidity run, but a run on one major financial institution after another because the creditors to those institutions suspected that they were being taken or that other creditors had reached this conclusion and were going to get their money out first.

"To prevent this run from taking down every major financial intermediary on the planet, the large central banks rode to the rescue with massive guarantees that tempered the crisis. But, truth be told, those guarantees are themselves subject to a massive run for the simple reason that they are nominal, not real (purchasing power) guarantees."

Kotlikoff pointed out that a full-scale run on US banks would require Ben Bernanke's Federal Reserve to print over $10 trillion to cover its guarantees. This printing presses working ovetime would trigger hyperinflation — precisely what I think the Fed has been seeking to avoid!

Kotlikoff proposes scrapping the existing system and reinventing finance with "limited purpose banks" at its heart, as I said in my earlier blog post. He said:

"Limited Purpose Banking doesn't break up large banks. It limits them to their legitimate purpose, namely, intermediation as opposed to gambling. And it forces them to turn on the lights and operate with full disclosure and complete transparency."

Under Kotlikoff's proposals, limited purpose banks would form the bedrock of a new financial system made up of clusters of small banks, with zero leverage, run along similar to mutual funds, and underpinned by some "very large limited purpose banks that sponsor them [and] would never fail".

Kotlikoff is confident that such a financial universe would end "financial collapse, which has been at the heart of so many terrible economic downturns over the centuries."

Given that we currently live in a financial dystopia—in which massive and immoral institutions have been able to retain their ability to privatize their gains and socialise their losses by weak governments (just look at what's just happened to Belgo-French basked bank case Dexia and the likely second bailout of RBS)—who am I to disagree?

Perhaps Kotlikoff ought to be wending his way down to Liberty Plaza in Lower Manhattan, as Professor Joseph Stiglitz had already done, to offer the Occupy Wall Street protestors some guidance on how to write a meaningful manifesto?

Further reading on the advantage of limited purpose banking:

Tags: Bank of England , banking , Ben Bernanke , Dexia , Federal Reserve , Greek economy , hyperinflation , Joseph Stiglitz , Laurence Kotlikoff , limited purpose banking , limited purpose banks , Mervyn King , Occupy Wall Street
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