A New Financial System

Laurence J. Kotlikoff and Edward Leamer put forward how the financial sector should be redesigned.

The system was supposed to channel our hard-earned savings into the best real investments: new homes, offices, factories, equipment and research. And it was supposed to correctly price our assets.

It did neither. Instead, Wall Street morphed into a vast gambling enterprise, generating massive trades of existing securities without, in fact, raising the investment rate or growing the economy.

During the dot-com bubble, Wall Street funded all manner of silly businesses, and during the housing bubble, it put millions of people in homes they couldn’t afford. This “expertise,” which cost one-tenth of our output, was delivered by the best and brightest, with half of Harvard’s graduating classes becoming high-class croupiers.

[…]

We need a financial sector but not one like this. Nor do we need Wall Street hitting us up for its gambling debts. What we need is Limited Purpose Banking (LPB), which would transform all financial corporations, including insurance companies and hedge funds, into mutual funds. They would, henceforth, be called banks.

Under this system, banks would never fail for a simple reason. They’d never hold any financial assets and they’d never borrow except to finance their mutual fund operations. Instead, they’d be limited to their legitimate purpose–financial intermediation. Under LPB, people, not companies, bear risk as their mutual funds do well or poorly.

A new Federal Financial Authority (FFA)–would rate, verify, supervise custody, disclose and clear all securities purchased, held and sold by LPB mutual funds. Private rating companies could stay in business, but no one would need to trust them ever again.

Banks would initiate personal and business loans (including mortgages), send them to the FFA for processing and then sell them to mutual funds, including their own. Loans would activate when sold, so no bank would ever have an open position.

All mutual funds would break the buck with one exception: cash mutual funds. These funds would strictly hold cash and be valued at $1 per share. Owners of these funds would write checks against their balances and never have to worry about a bank run. Fractional reserve banking and the FDIC would be history.

LPB would include insurance mutual funds. These funds would pay off based on the losses experienced by contributors. If losses are larger than expected, less is paid out per loss. Hence, LPB prevents insurance companies from insuring the uninsurable, e.g., claiming they’ll pay the same life insurance claims even if there’s a plague.

All risk allocation arrangements can be run through mutual funds, including credit default swaps. Take a bank that markets the GE-Defaults-On-Its-Bonds-In-2010 fund. Under this closed-end fund, shareholders specify in advance if they want to get paid off if GE does default on its bonds in 2010 or paid off if GE doesn’t default. All money put into the fund, less the mutual fund’s fee, would be held in one-year Treasuries and paid out at the end of the year to the winning shareholders in proportion to their holdings.

Photo by Flickr user Derren Hester, used under Creative Commons license.

FILED UNDER: Economics and Business, Government, ,
Steve Verdon
About Steve Verdon
Steve has a B.A. in Economics from the University of California, Los Angeles and attended graduate school at The George Washington University, leaving school shortly before staring work on his dissertation when his first child was born. He works in the energy industry and prior to that worked at the Bureau of Labor Statistics in the Division of Price Index and Number Research. He joined the staff at OTB in November 2004.

Comments

  1. odograph says:

    I have a problem with the first paragraph:

    The system was supposed to channel our hard-earned savings into the best real investments: new homes, offices, factories, equipment and research. And it was supposed to correctly price our assets.

    What he calls “real” investments fall into two categories: productive and non-. A granite counter-top may provide satisfaction, but it probably will not provide future income(*), as would an equivalent investment (via stocks or bonds) in offices, factories, equipment and research.

    (*-If your granite counter-top increases return on an actual, not hypothetical, rental property, that’s different. Research shows however that such improvements seldom turn a profit in home resale. The “investment” in most home improvement yields lower return than T-Bills. The only exception is probably when you buy and repair a genuine wreck. “Flip this house” worked, for a time, because the market was crazy, not because the improvements made all the appreciation.)

  2. Steve Verdon says:

    What he calls “real” investments fall into two categories: productive and non-. A granite counter-top may provide satisfaction, but it probably will not provide future income(*), as would an equivalent investment (via stocks or bonds) in offices, factories, equipment and research.

    Where do you see granite counter-top? I see new homes, which may or may not have granite counter tops, but the point is you have a new house.

  3. Brian Knapp says:

    It did neither. Instead, Wall Street morphed into a vast gambling enterprise, generating massive trades of existing securities without, in fact, raising the investment rate or growing the economy.

    During the dot-com bubble, Wall Street funded all manner of silly businesses, and during the housing bubble, it put millions of people in homes they couldn’t afford. This “expertise,” which cost one-tenth of our output, was delivered by the best and brightest, with half of Harvard’s graduating classes becoming high-class croupiers.

    This reminds me of the great movie “Boiler Room”. The movie contrasted what the protagonist did in his in-home gambling operation with his “Wall street” day-trading gig. It also showed the brokerage investing in fake businesses and selling them to investors. Which, of course, led to bad things. It may have been the most prophetic movie ever. Other than maybe “The Siege”.

  4. Dave Schuler says:

    I’ve read this before from these same guys. I’m not sure where. Could it have been on their blog?

    Sensible as this sounds I doubt it will ever come to pass. The existing financial institutions will hate it like poison. The politicians who’ve been profiting by the revolving door will prevent it from happening because the financial institutions hate it.

  5. Dave Schuler says:

    One more point. As I understand their proposal if it were to be adopted the only basis that financial institutions would have to compete on would be price. Large “banks” (using the new definition) would have no advantage over small ones.

    That’s enough of a reason that it will never be adopted.

  6. odograph says:

    Houses are still non-productive assets. The do not generate income and in most regions only track inflation.

  7. DL says:

    Please someone explain to me how “Wall Street” put millions of people into homes they couldn’t afford. I understand the politicians forced the banks to lend to the high risk clients through CRA and FNMA etc. But I wouldn’t pin the rap on “Wall Street per se.

  8. odograph says:

    Sorry DL, it is false that politicians forced banks to make bad loans. No one has ever found a law that required that.

    The connection to “Wall Street” is tenuous as well, because the CountryWide Financial corporate offices are actually in Calabasas, California. Folks like CountryWide “innovated” people into bad loans, by packaging and passing them on to the bond market (perhaps “Wall Street”) with a AAA rating.

    People around the world bought bonds full of bad loans because we (in the broad sense we, the US business community) said they were safe as … houses.

  9. Steve:

    I’d actually be interested in hearing what you think of this proposal. Isn’t it a tremendous level of regulation? Why shouldn’t people be allowed to borrow money to make investments?

    For a guy who went ballistic when Obama fired the board of directors of a company receiving a government bailout, you now seem to be endorsing a tremendous government intervention to limit free enterprise.

    Or do you oppose this proposal.

    Walk us through it, if you would.

    –BF

  10. odograph says:

    My feeling is that extreme restructuring is probably not required, just because no one is likely to make the same error any time soon.

    Credit will not be extended with CountryWide abandon, until people forget … which might take a generation.

  11. odograph says:

    BTW, I have a proposal I’ve never shared, but which I think is actually pretty good:

    Limit FDIC insurance to $250K for business or individuals, but pay out at 95% of loss.

    That would be enough to eliminate the free riders on FDIC protection and kill the moral hazard. I would not (as I did and do) have money in CountryWide bank, because I’d have the aversion to losing 5%. And paying out 95% when things actually fail would be enough to halt system failure.

    Overall I think this would be enough to drive deposits to conservative institutions.

    (Securitization would creep back in over time, but most people will stay away.)

  12. Steve Plunk says:

    It all goes back to having Boards of Directors who failed us. They created compensation packages that rewarded short term over long term. They failed to understand the businesses they were supposed to oversee. They hired management personnel for the wrong reasons. They set corporate policies contrary to good business plans.

    The unfortunate thing is they all remain without so much as a blemish on their reputations. Until the big institutional investors and mutual funds start electing good Boards we will continue to have problems.

  13. Steve Verdon says:

    Odograph,

    Houses are still non-productive assets. The do not generate income and in most regions only track inflation.

    Not true, they provide shelter for people. As such they have value. Simply because you can’t identify a cash flow year-to-year does not make them unproductive. By this kind of reasoning a personal car is unproductive. Consumer durables are unproductive. Etc.

    Bernard,

    I’d actually be interested in hearing what you think of this proposal. Isn’t it a tremendous level of regulation? Why shouldn’t people be allowed to borrow money to make investments?

    People would be allowed to borrow money to make investments.

    From the article:
    Banks would initiate personal and business loans (including mortgages), send them to the FFA for processing and then sell them to mutual funds, including their own. Loans would activate when sold, so no bank would ever have an open position.

    For a guy who went ballistic when Obama fired the board of directors of a company receiving a government bailout, you now seem to be endorsing a tremendous government intervention to limit free enterprise.

    I don’t believe I went ballistic. I was perhaps sarcastic and snarky, but I don’t think I was so upset as to call it ballistic.

    I also fail to see your snarky comments in this post by James which has a similar take on what happened with the auto companies as I did in this post where you called me an idiot.

  14. sam says:

    @Dave

    The existing financial institutions will hate it like poison.

    That’s enough for me; I’m onboard.

    And what Steve Plunk said.

  15. sam says:

    And I really, really hope Tom Wolfe has enough juice left and the inclination to turn himself to this f-cking debacle.

  16. I also fail to see your snarky comments in this post by James which has a similar take on what happened with the auto companies as I did in this post where you called me an idiot.

    James didn’t make the idiotic comparison of Obama’s actions to the Soviet economy, now did he?

    Now, back to this post… I am still confused.

    Under this system, banks would never fail for a simple reason. They’d never hold any financial assets and they’d never borrow except to finance their mutual fund operations.

    Doesn’t that suggest no ability to leverage?

  17. Steve Verdon says:

    Bernard,

    James didn’t make the idiotic comparison of Obama’s actions to the Soviet economy, now did he?

    Implicitly he did. He noted that it was unlikely that political appointees would be able to run a business as well as business people, as a general principle. For example, James wrote,

    The 10 senior aides advising the task force include economists, professors and former Obama campaign aides.” Well, who better than professors and politicos to run a multinational auto company? (If it’ll make you feel better, the team is ” headed by former investment banker Steve Rattner.” That does make you feel better, right?)

    I noted the extreme case of the Soviet Union, but if you want another example we could look at Amtrak. I think it could also be argued the GSE’s like Fannie Mae and Freddie Mac would also fit the bill, and they didn’t too all that well either.

    Doesn’t that suggest no ability to leverage?

    No.

  18. He noted that it was unlikely that political appointees would be able to run a business as well as business people, as a general principle.

    Which has nothing… at all… to do with how the Soviet Union conceived and ran its centrally planned economy. I am just going to chalk this up to my suspicion that you are probably a few years younger than me and as a result never had the need or opportunity to study the Soviet economic system closely.

    Doesn’t that suggest no ability to leverage?

    No.

    Okay… well, then I admit, I don’t understand the proposal. I’ll take it on your word that it is worth my time and will try to explore it further.

  19. odograph says:

    Steve, I will direct you to the web page:

    What are productive assets?

    Sure there are good reasons to own, rather than rent, shelter. Your future costs are inflation protected, if you do pay down the mortgage, rather than trading up in what for some is an endless cycle.

    … but the term “productive asset” has a concrete meaning.

  20. odograph says:

    By this kind of reasoning a personal car is unproductive.

    I Corolla might be productive, a Dodge Charger, less so.

    And really the Corolla vs Charger, shelter vs 5000 sq ft showplace, thing is what I’m getting at.

    People who had shelter, and had transportation, made the really key error that buying more indulgences was somehow investment.

  21. Steve Verdon says:

    Bernard,

    Which has nothing… at all… to do with how the Soviet Union conceived and ran its centrally planned economy. I am just going to chalk this up to my suspicion that you are probably a few years younger than me and as a result never had the need or opportunity to study the Soviet economic system closely.

    I guess that the Soviet Union didn’t make production decisions based on politics. I’ll just go with your vastly superior knowledge.

    Okay… well, then I admit, I don’t understand the proposal. I’ll take it on your word that it is worth my time and will try to explore it further.

    Leverage is where you use borrowed funds to augment existing funds to enhance the positive or negative returns on an investment. Investment is used in the broadest possible sense. Here are some examples:

    1. A firm wants to engage in a $10 million dollar venture producing a product. They have $1 million dollars, have a sound business plan, have done their due diligence, and have an excellent credit record. They borrow $9 million. They just used “leverage”.

    2. You want to buy a house, but only have 20% of the cost. You go to your bank and fill out the forms. You demonstrate reasonably secure employment, some assets that are illiquid, and have a good credit history. You borrow the remaining 80%. You have just used leverage.

    3. An investor wants to speculate in the stock market so he goes and buys stock on margin: borrowing funds to purchase the stock. (Note: derivatives are a type of leveraging. I suspect that this is what you were thinking about.)

    All three cases are viable under the Leamer-Kotlikoff proposal provided their are people out there in the economy willing to buy these loans. Once the loans are bought, the people applying for the loans get the funds necessary for their desired investments. As you could probably imagine the last example would likely have a tougher time finding buyers. As such margin purchases of stocks and other financial instruments would likely decrease. Not due to regulations per se, but because investors–you, me, James and others, would likely not want to take on such risk.

    Why is this an improvement over what we have now? You, me, James and everyone else are already, in effect, underwriting these margin type purchases of financial instruments. We are doing so with tax dollars. The problems with this approach is manifold. I don’t think I have to explain these problems.

    Odograph,

    I see real estate property as a productive asset. Whether you rent or own is a side issue. As for the size, that is a personal issue and one I’d be hesitant to get into. My current house is sufficient, but it would be better for me and my family if it was bigger.

  22. odograph says:

    Steve, one person has a $200K house and $800K in stocks and bonds. The other has a $800K house and $200K in stocks and bonds.

    Who has more productive assets? Who is contributing more to the future growth of the US economy? Who is more likely to survive retirement?

    Too many people in the US, California esp., took the $800K house, $200K portfolio, path.

    I’ve been told that the Talmud has an ancient recommendation: 1/3 cash, 1/3 business, 1/3 real estate. Translating cash to FDIC insured accounts, business to personal business or stocks, and real estate to home, might not be a bad strategy.

    Of course, income property takes that real estate piece quite a bit further in the “productive” direction.

  23. odograph says:

    Related, recommended:

    A Crisis of Ethic Proportions

  24. Steve Verdon says:

    Steve, one person has a $200K house and $800K in stocks and bonds. The other has a $800K house and $200K in stocks and bonds.

    So? I don’t care if a person wants to use their savings, credit and income in either way.

    Who has more productive assets? Who is contributing more to the future growth of the US economy? Who is more likely to survive retirement?

    Depends, an $800k house right now in Los Angeles or in San Francisco would likely do quite well in say 10 or 20 years. It would be a nice home, not huge, and would likely end up being worth more than the $800k in stocks and bonds. For example, I’m sure that one reason my house appreciated was due to the crazy real estate market. But given all the other development around where I live I figure another part is due to legitimate reasons. Given when we bought the home, etc. I think we’ll end up with a decent investment in the end.

    Besides, I believe in letting people make mistakes.

  25. odograph says:

    This is a little bit of a trap Steve, in a loose way associated with that “crisis of ethic proportions.”

    People can make mistakes, but when one country borrows like mad for lifestyle and personal consumption, and another saves and invests in production … one loses position.

    You can complain all you want about America becoming the new Britain in its decline, but if you and everyone spends on cars and houses … what do you expect?

    Why is China suddenly rich? Is it because they all bought big houses?

  26. I guess that the Soviet Union didn’t make production decisions based on politics. I’ll just go with your vastly superior knowledge.

    Yes… but that wasn’t one tenth of the problem.

    The enterprises in the Soviet Union didn’t have a bottom line. They just had production targets. These were usually set at some arbitrarily defined increment of last year’s production. The production targets had no relationship with the marketability of the products that would result. It just didn’t matter if no one wanted to buy the goods. The managers were incentivized almost purely on hitting production numbers.

    Firms in the Soviet Union didn’t pay for raw materials. They requisitioned them, and these were allocated by a combination of politics, bribery, inertia, etc.

    The result was that Soviet firms were essentially about gaming production targets. They would request more material than necessary — the surplus being wasted or sold on the black market. They would game production so that they made their production quotas, but just barely so that their targets would not ratchet too far forward.

    In the case of GM, etc, the argument is that people appointed politically would not be the best judges of how to manage a business and understand market incentives. In other words, they they would be suboptimal managers in a free economy.

    That has nothing to do with a system where there is no concept of cash flow, no cost for raw materials, no rewards or consequences if your products are not marketable, etc.

    I swear Steve, this is one of those cases where you just simply do not know what you are talking about.

    Read a damn book about the Soviet economy, and if you’re a honest man you’ll come back here and admit you were talking out your ass.

  27. Steve Verdon says:

    Odograph,

    People can make mistakes, but when one country borrows like mad for lifestyle and personal consumption, and another saves and invests in production … one loses position.

    I don’t subscribe the mercantilism.

    Bernard,

    I agree with and knew all of that save the last two lines. Yes it was the extreme case, but it is on the same side of the spectrum (FYI, I’d argue all of your explanations are “political” since it was all part of the political system in the Soviet Union). You are arguing about matters of degree only.

    And part of the problem with having a board of directors hand picked is that they wont be making decisions based on a bottom line as in the Soviet Union. Firms set production targets right now. For most firms it is based on the bottom line (although not in all cases, for example regulated utilities are required so meet all demand at rates determined by a regulatory process–i.e. not just on profit maximization). Now with a politically oppointed board of directors what is to say that politics wont enter into that decision, marketability being relegated to a secondary role at best?

    Maybe you should read a damn book on economics so you don’t talk out of your ass. Please don’t tell me you have, you didn’t know about leverage/borrowing. A fairly basic goddamned concept.