Jimmy Stewart Is Dead

Ending the World's Ongoing Financial Plague with Limited Purpose Banking

Laurence J. Kotlikoff

• Publisher: Wiley
• Year: 2010
• Print ISBN:
  9781118011331
  9780470581551
• eBook ISBN:
  9780470609019
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Negocios en general

Discover how the global financial plague is poised to return, and what can be done to stop it

This is not your father's financial system. Jimmy Stewart, the trustworthy, honest banker in the movie, It's a Wonderful Life, is dead. And so is his small-town bank, Bailey Savings & Loan. Instead, we're watching It's a Horrible Mess with Wall Street (aka the Vegas Strip) playing ever larger craps with our economy and our tax dollars.

This book, written by one of the world's most respected economist, describes in lively, humorous, simple, but also deadly serious terms the big con underlying the big game?the web of interconnected financial, political, and regulatory malfeasance that culminated in financial meltdown and brought us to our economic knees. But it also proposes an amazingly simply solution?Limited Purpose Banking to make Wall Street safe for Main Street.

• This book, as well as the financial fix described within it, have received rave reviews from a veritable who's who of policymakers and economics, plus five economics Nobel Laureates
• Written by a leading economist whose insights on this topic are unparalleled
• Outlines the first and only proposal to fundamentally fix our financial disaster for good

Jimmy Stewart Is Dead will fundamentally change the way you think about the economy, financial markets, and the government.

Chapter 1

It’s a Horrible Mess

Each financial crisis is different, yet they all feature financial institutions making promises they can’t keep. “This is a sure bet.” “My strategy beats the market.” “This loan is triple A.” “Our capital’s adequate.” “Your money’s safe.” “Don’t worry.”

Well, we’re worried. The financial market has melted down, and with it trust in a system that routinely borrows short and lends long, guaranteeing repayment yet investing at risk. It’s a system virtually designed for hucksters, with limited liability, fractional reserves, off-balance-sheet bookkeeping, insider-rating, kick-back accounting, sales-driven bonuses, nondisclosure, director sweetheart deals, pension benefit guarantees, and government bailouts.

It’s a Wonderful Life, the beloved Christmas movie, showed just where this can lead: an otherwise honest banker, George Bailey (played by Jimmy Stewart), confessing to a mob of angry demand depositors that, in fact, he’d lied—that Bailey Savings & Loan can’t return all their money on demand. Despondent and about to take his life, God sends an angel to save George and his bank just in the nick of time.

The movie’s ending is happy, but its underlying message is not: Our financial system, as designed, is fantastically fragile, perched atop a pillar of trust that can instantly be undermined. Check that, was undermined! For here we sit with our financial pillar in ruins, watching Uncle Sam desperately trying to glue the pieces back together.

It’s Not Bailey Savings & Loan

Uncle Sam’s strategy—fight each financial fire one by one and rebuild the old system pretty much as was—is deeply misguided. It treats the symptoms, not the disease, and will leave us financially and fiscally weaker.

The financial community has close ties to Sam, marked by massive campaign contributions to both parties, and is working overtime to make sure Sam doesn’t rock their boat. Their mantra is “The financial crisis was caused by a housing bubble, spurred by the Federal Reserve’s low interest-rate policy and lax regulatory oversight. The system is fundamentally sound and critical to our economy. We haven’t seen anything like this in 80 years. Yes, some bad apples took on too much leverage, but trust us. ‘We’re doing God’s work.’¹ We’ll make sure it doesn’t happen again. We bankers know what we’re doing, and our financial judgment is critical for allocating credit and choosing investments.”

The notion that bankers know what they are doing or can keep this from happening again is risible given everything we’ve seen. And the proposition that banking as usual is essential to our economy as opposed to extremely dangerous is predicated on a quaint view of banks that bears little resemblance to today’s reality.

Bailey Savings & Loan is not your local bank. Your local bank is Bank of America, Citigroup, JPMorgan Chase, or one of the other ten largest banking conglomerates, whose headquarters are hundreds, if not thousands, of miles away and who have taken over most of the banking business.²

And 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 when the economy generates positive and high returns on investments.

This is by no means to suggest a conspiracy of bankers, but rather to point out that bankers, like members of other professions, are self-interested and have managed to set up a system that works for them, even if doesn’t work for the country. Nor do I imply that bankers, as a group, lack financial judgment, integrity, or a social conscience. Most are fine people doing their best by their clients. But their ranks, particularly their top ranks, include a remarkably large number of fast-talking con artists, riverboat gamblers, and highway men whom you’d never trust with your money, let alone your kids, if you really got to know them.

Both the good-guy and the bad-guy bankers are working within a regulatory system designed in the 1930s for Bailey Savings & Loan, not for today’s world of global finance, exotic financial securities, computerized electronic trading, and enormous trade volume that George Bailey could not begin to fathom. Today, more trades are conducted on the New York Stock Exchange in a single day than were conducted in all of 1929.³

The new technologies have not only increased the speed of financial transactions; they’ve also reduced the costs. This translates into better terms for those needing to raise money by selling assets (e.g., borrowing or issuing stock) and higher returns for those willing to supply money by buying assets (e.g., lending or purchasing stock). But as the spreads to intermediation got squeezed, many financial players started looking to make money the old-fashioned way—by stealing it.

Some of this theft involved simply pocketing investors’ money, with Bernard Madoff and Allen Stanford being prime examples. But most involved selling snake oil, including complex bundles of incredibly crappy (to use technical language) mortgages, which were stamped AAA by the principal rating companies—Standard & Poor’s, Fitch, and Moody’s. The rating companies delivered their “appraisals” in exchange for huge payments and after verifying that these mortgages had been “insured” by AIG, MBIA, or some other malfeasant insurer, which the rating companies had, themselves, rated AAA.

The complexity of these securities, the implicit bribing of rating companies, the deceit of mortgage initiators, the incompetence of regulators, the sales-based compensation of management, the complicity of corporate directors, the collusion of bankers and politicians, and the naiveté of investors—all quickly turned the sale of snake oil into a multi-trillion-dollar industry. The collapse of this industry has exposed our financial system for what it is—fundamentally corrupt, incredibly fragile, and never again to be trusted.

Unfortunately, there is no putting the genie back in the bottle. We can’t return to yesteryear and outlaw what has become a $600 trillion market in derivatives.⁴ (Yes, you read that right.) We can’t eliminate the securitization of loans, bar financial innovation, or expect global bankers to act in loco parentis. We can’t ban subprime mortgages, credit default swaps, collateralized mortgage obligations, or other so-called toxic assets. Nor can we limit credit only to those with good ratings, stable jobs, and plenty of collateral.

In short, we’re stuck with financial modernity for better and for worse. But, as we’ve seen, financial modernity goes far beyond what our old financial regulatory and rating system can handle. It’s also far beyond what Uncle Sam can handle. His decision to bail out the banking sector, the mortgage industry, the insurance industry, the money market fund industry, the auto industry, the credit card industry, the states, the housing industry, the student loan industry, small business, the RV industry, the rental car industry, the boating industry, the snowmobile industry, and Lord knows who’s next invites ongoing gambling at the public expense by any business or entity that can reasonably expect a bailout if push comes to shove.⁵ This is a prescription for fiscal insolvency, which could culminate in hyperinflation as the government finds that the only way it can get enough money to cover all its handouts is by printing it.⁶

The printing presses are already running overtime. The monetary base measures the amount of money Uncle Sam prints in order to buy things, whether those things are financial securities, tanks, space ships, or lunch for the president.⁷On January 1, 2008, the monetary base totaled $831 billion. On June 1, 2009, it stood at $1.8 trillion!

Uncle Sam printed more money (just shy of $1 trillion) over those 18 months than was printed in the entire history of the republic.⁸ And he’s just revving up. The Federal Reserve has pledged to print another 1,750,000,000,000 dollars ($1.75 trillion) during 2009 to lower long-term interest rates and thereby continue to bail out the economy. That translates into more than a quadrupling of the monetary base in two years and could, if banks start lending again, culminate in a quadrupling of the nation’s M1 money supply and, ultimately, of prices!⁹

The authors of this policy know they are playing with fire—the economy could quickly flip from experiencing today’s low inflation or even deflation to hyperinflation. The policy’s chief architect, Federal Reserve Chairman Ben Bernanke, is an exceptionally thoughtful, responsible, and cautious person, not to mention an outstanding economist. The fact that he’s pulling out the stops to this unprecedented extent speaks volumes for the gravity of the situation.

But throwing money at the problem is no long-term solution. It does nothing to fix the system’s underlying problems, which requires tough love, not endless handouts. The right path forward is not exhuming Jimmy Stewart, applying some makeup, and propping him up in the bank window. Given what it’s learned and lost in this financial debacle, the public would no longer trust Jimmy Stewart in the flesh, let alone the bone. The right path forward is Limited Purpose Banking.

Talking Turkey with Wall Street

Boys and girls, the party’s is over. You have one job and one job only—financial intermediation. If you want to gamble, be our guest. But do so on your own time, in your own home, and on your own dime. As a group, you are not to be trusted. So we’re going to let you exercise your significant skills and generally good judgment, but in a way that doesn’t threaten our savings, jobs, and families. From here on out you’ll have to work within a new financial system, called Limited Purpose Banking, that makes you stick to your legitimate purpose—financial intermediate.

Look around. The one part of your industry still standing is the mutual fund industry, which generally stuck to its knitting—connecting suppliers of and demanders for funds. The reason is simple: mutual fund companies, with a few exceptions, didn’t play craps with their company’s capital.

Limited Purpose Banking transforms all of the financial corporations in which you work—whether they are called commercial banks, investment banks, hedge funds, insurance companies, private equity funds, venture capital funds, brokerages, credit unions, or something else—into pass-through mutual fund companies.¹⁰

None of your companies, which we’ll just call banks, will ever again be in a position to fail because none of your banks will ever again be allowed to borrow short and lend long and leave the public to pick up the pieces. The public ultimately bears the risk of investment and the public, with your proper help, is going to decide what risks to take and what risks, including systemic financial collapse, to avoid.

All banks will be subject to the same regulation, regardless of their particular line of business. A single federal regulator, the Federal Financial Authority (FFA), will verify, disclose, and supervise the custody and independent rating of all securities held by all mutual funds. This will put an end to the pervasive fraud that now attends your initiation and sale of vast numbers of securities.

Limited Purpose Banking is a real, as opposed to cosmetic, fix of the financial system—one that gets and keeps Uncle Sam off Wall Street’s hook. Such a fix is essential not only for healing the financial sector, but for achieving overall economic recovery. By itself, the financial sector accounts for over 20 percent of U.S. GDP.¹¹ And, like gas stations, its operations are vital to the rest of the economy’s performance. But no one is going to rely on financial companies if they can’t trust what they are doing and selling. Wall Street has completely and irrevocably squandered the public’s trust. And left to its devices, Wall Street will keep chasing the almighty buck no matter the risk to the economy, including a rerun of the Great D.

Economics Diary, Spring 2009: The D Word

“Depression” is a word that no economist likes to say. But today it’s on the tips of everyone’s tongues, and for good reason. The economy is imploding at a rate we’ve not seen since the 1930s. Output is dropping at a 6 percent annual rate, exports are off 15 percent, and the financial system is on life support.¹² The one industry doing well is the bread line. Food stamp applications have hit record highs, and one in three of our nation’s children are now on this dole.¹³

More than 500,000 workers are losing their jobs each month. Close to one in ten Americans—some 12.5 million people—are now out of work. Housing starts are at 50-year lows, and foreclosures are at all-time highs.¹⁴ Two million families lost their homes last year because they couldn’t pay the mortgage.¹⁵ Another 17 million may shortly join their ranks.¹⁶

Everyone is scared. The jobless are worried sick, and those with jobs are sure they’re next on the chopping block. The elderly are in acute shock. Many have seen their retirement assets fall in half and their dreams of a comfortable retirement evaporate.

Our children are feeling our pain and asking us what happened. Our answer is that we don’t know. We thought we had well-functioning banking and insurance companies with competent directors, world-class managers, responsible regulators, and incorruptible rating companies. But overnight, we learned it was a sham—that while we were hard at work, much of the financial, regulatory, and rating system was busy producing, whether intentionally or not, trillions of dollars worth of assets we now call “toxic.”

One financial giant after another has crashed to the ground. They’ve either gone broke, been forced to reorganize, had to raise equity at fire-sale prices, been fully or partially nationalized, been bailed out, or changed charters to garner FDIC insurance protection.¹⁷

Countrywide Financial, Bear Stearns, IndyMac Bank, Fannie Mae, Freddie Mac, L...

Table of contents

• Praise
• Title Page
• Copyright Page
• Dedication
• Foreword
• Preface
• Acknowledgements
• Chapter 1 - It’s a Horrible Mess
• Chapter 2 - The Big Con
• Chapter 3 - Uncle Sam’s Dangerous Medicine
• Chapter 4 - “This Sucker Could Go Down”
• Chapter 5 - Limited Purpose Banking
• Chapter 6 - Getting from Here to There
• Chapter 7 - What About?
• Chapter 8 - Conclusion
• Afterword
• Notes
• About the Author
• Index