Fixing our financial system with limited purpose banking

“Twas the year the country stood still. Not a car, truck or bus traveled the roads. No one drove to work, no one drove to shop, no one drove to visit. No one drove anywhere. The reason was simple. No one could buy gasoline. The gas stations had all gone broke.

Their owners had tired of netting pennies on the gallon. They wanted their earnings to grow. The big money, they learned from a bright young MBA, was in securitizing their services. So they started selling GODs — Gas Options for Drivers.

Each GOD gave the driver the option to fill his or her tank for $4 per gallon. Drivers bought GODs religiously. And with gas selling for $3 a gallon, station owners didn’t worry.

Then the unthinkable happened. Gas prices skyrocketed to $6 a gallon, and drivers began invoking their GODs. Each GOD could save the buyer $2 a gallon, and if you didn’t need gas, you held up a sign — “GODs for Cash!”

Station owners began cursing the GODs. They now had to buy gas at $6 a gallon and sell it for $4. In short order, the owners went bust. They closed their stations and started looking for jobs in financial services. GODs became worthless. Overnight, there was no gas for the nation’s 250 million vehicles, and the economy ground to a halt.

The economic moral is simple. If you want markets to function, don’t let critical market makers — intermediaries who connect suppliers (e.g., refineries) with customers (e.g., motorists) of essential products — gamble with their businesses.

Apply the moral to banks (shorthand for all financial corporations, including insurance companies) and the regulatory prescription is clear. Limit banks to their legitimate purpose — connecting lenders with borrowers and savers with investors — and don’t let them gamble.

Would that we had heeded this injunction. Instead, we let Wall Street play craps with our financial system, our economy and our tax dollars. The result — we lost big-time. There was a big con underlying this game — a web of interconnected financial, political and regulatory malfeasance that culminated in a financial meltdown and brought us to our economic knees. It’s a story with everyone on the take, with a host of villains committing first-, second-, and third-degree economic murder, leaving millions upon millions of victims at home and abroad.

Others have told and are telling this story. They are primarily financial journalists and Wall Street traders. Their insider details are both fascinating and horrifying. But conveying the facts is not the same as assessing their economic meaning. That’s primarily the responsibility of economists, of which I am one. We economists are charged with understanding and protecting the economy; we’re supposed to spot economic disasters before they arise, and recommend solutions.

Unfortunately, we failed in our fiduciary duty. 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 now are trying resurrect the system that failed so miserably.

The rest of us — academic economists like myself — were perched in ivory towers, too high above deck to see the pervasive financial malfeasance that was under way. We had a clear view — had we looked — but we were researching our imaginary world where people play by the rules. Consequently, we had even less of a clue that the nation’s largest financial companies, aided and abetted by the ratings companies, politicians and regulators, were madly driving our economy straight toward the rocks. They reached their destination. The economy is now firmly on the shoals and still in danger of completely breaking up.

Given that our economy is in Defcon 1 or very close to that condition, it’s all economic hands on deck. Every economist has an obligation, regardless of her or his area of specialization, to focus on this economic emergency — to understand what really went wrong and to help make sure this never, ever happens again.

To be clear, my main area of expertise is not finance. It’s fiscal affairs, particularly the sustainability of our tax and spending policies and their implications for the next generation. But I’ve also worked on a range of other issues, including economic growth, saving, international trade, pensions, insurance, health reform, tax reform, Social Security and personal finance.

Studying a range of economic issues provides a broader perspective when considering the problem at hand. It also helps to keep away from financial conflicts of interest in weighing Main Street’s interests against Wall Street’s. In my case, my bread isn’t buttered by financial companies but by an independent academic institution, Boston University. Unlike my economic brethren working on Wall Street and many of those working in Washington, I don’t need to worry that what I say will affect what I earn now or in the future. I’m also free of political constraints. I’m not a registered anything and am beholden to neither political party.

But full disclosure requires full disclosure. Breadth, distance from the Street, and mostly armchair policymaking come at a cost. The more we know about everything, the less we know about anything. In my case, I’m not an expert on all the intricacies and imperfections of asset pricing, exchange trading, risk appraisal, dynamic hedging and securitization.

And I can’t quote line and verse from banking regulations, or tell you precisely how to construct a collateralized debt obligation squared or other exotic derivatives.

Fortunately, for the critical matter at hand — fixing our financial system — seeing the forest is much more important than naming all the trees. My goal then is not just to survey the amazing and disheartening events surrounding our economic shipwreck but to convey their deeper economic meaning, particularly the extraordinary danger of maintaining the financial status quo, and to propose a solution that follows from the terrible facts.

The right financial fix, called limited purpose banking, is remarkably simple and easy to implement. And it can be accomplished without limiting credit, risk taking, insurance, leverage or any other economically vital financial behavior or service. Most important, limited purpose banking will immediately restore trust in our financial system, which is the ultimate action needed to revive the economy and its long-term prospects.

Limited purpose banking is a simple and very low-cost change to our financial system, which limits banks to their legitimate purpose, namely connecting borrowers with lenders and savers with investors. The costs of limited purpose banking are negligible for a good reason. The reform builds off the existing mutual fund industry, which has been functioning very smoothly for more than half a century. It also dramatically rationalizes and simplifies financial regulation.

Under limited purpose banking, all banks — all financial and insurance companies with limited liability (e.g., C corporations, S corporations, LLPs) that are engaged in financial intermediation — would operate as pass-through mutual fund companies, which sell mutual funds — safe as well as risky collections of securities. That is, the banks would simply function as middlemen. They would never themselves own financial assets or borrow to invest in anything except those specific assets, such as computers, office furniture and buildings, needed to run their mutual funds’ operations. Hence, banks would never be in a position to fail because of ill-advised financial bets.

No-risk banking? Yes, no-risk banking. Intermediation requires no risk taking whatsoever. And we’ve just had an object lesson in what happens when you let intermediaries gamble — they can go broke and, in the process, drive the country broke. With limited purpose banking, financial intermediation never breaks down. Moreover, we the people are never leveraged and consequently never subjected to “economic blackmail,” as Federal Deposit Insurance Corp. Chairwoman Sheila Bair put it.

In considering limited purpose banking, please bear in mind that the proposal isn’t coming completely out of left field.

If you look carefully at some of the reform ideas emanating from Congress these days, you will see a number of LPB-type features. But you will also see that they come attached with a very heavy hand and unnecessary dose of government regulation and financial micromanagement, not to mention political kickbacks masquerading as reform.

This is no surprise. If we let the Street’s Jimmy Caynes continue to call the shots, we have two options.

Either we have federal regulators sit at their elbow while at work and shadow them when they leave the office or we make their every significant move subject to federal government approval.

This amounts to effective nationalization of the banking system and the end of free financial enterprise.

In my view, we are likely to flip from dramatically underregulating to dramatically overregulating the financial sector, while still leaving the system at risk

Using limited purpose banking as a financial fix is wholly different from the policies pursued to date to rescue the banks and insurance companies. Those policies have administered elixirs when the patient is in cardiac arrest. They’ve made the patient more comfortable but done nothing to cure his underlying disease. Worse yet, the palliatives are extremely expensive and highly addictive.

The gurus applying these “cures” have a vested interest in preserving the status quo. Their focus is on the next election and, far too often, their next job. What they’ve ignored is the next generation, which can neither afford their solutions nor tolerate their tinkering. Young, trusting economic lives are at stake, and nothing short of economic open-heart surgery will save the full American dream.

Excerpted from “Jimmy Stewart is Dead: Ending the World’s Ongoing Financial Plague with Limited Purpose Banking” (John Wiley & Sons Inc., 2010). Mr. Kotlikoff is a William Fairfield Warren Professor of Economics at Boston University.

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