NCPA - National Center for Policy Analysis

IT'S TIME TO INSTITUTE 'LIMITED-PURPOSE BANKING'

May 26, 2009

The Obama administration's strategy to address the economic crisis may be making the problem worse, say Laurence J. Kotlikoff, a professor of economics at Boston University, and John C. Goodman, president and CEO the National Center for Policy Analysis.

Its plan -- bailing out one financial institution after another and rebuilding the old system pretty much as was -- treats the symptoms, not the disease, and will leave us fiscally and financially weaker.  The disease is letting financial companies borrow in order to gamble, resting easy that Uncle Sam will cover their losses.  The more the government enables this behavior, the more financial companies will gamble at public expense and the greater the chance of systemic collapse.  Creating a "limited-purpose-banking" structure is a better way to restore trust in our financial system and get our economy rolling.

It is a simple and essentially costless change that limits banks to their legitimate purpose, which is connecting, and intermediating between, borrowers and lenders, and savers and investors, explain Kotlikoff and Goodman:

  • Under limited-purpose banking, all financial corporations engaged in financial intermediation, including all banks and insurance companies, would function exclusively as middlemen selling safe as well as risky collections of securities (mutual funds) to the public.
  • They would never own financial assets; therefore, they would never be in a position to fail because of ill-advised financial bets.

The government has been going to extraordinary lengths to cover the financial sector's losses, running astronomical deficits and printing money like crazy.  But the government also is making promises that it can't keep, say Kotlikoff and Goodman:

  • Take the Federal Deposit Insurance Corp.'s insurance; a bank run today would cost the FDIC of Washington $4.8 trillion -- far beyond its $19 billion reserve.
  • Or consider federal promises to cover bills for American International Group Inc.; the government has already committed $173 billion to AIG, but the New York company still has $1.6 trillion in credit default swap exposure.
  • Were AIG or some other large insurer to fail, we could see a run on the industry's roughly $3 trillion in cash surrender value, which the government would surely cover.
  • Then there is Ford Motor Co., General Electric Co. and General Motors Corp., among many other companies, that the government has deemed or might deem "too big to fail."
  • And let's not forget the government's guarantees of private-pension funds; that liability could run to $100 billion.

Source: Laurence J. Kotlikoff and John C. Goodman, "It's time to institute 'limited-purpose banking,' " Investmentnews.com, May 24, 2009.

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