Posted by: Dirk | May 11, 2010

[Book review] Jimmy Stewart is dead

subtitle: Ending the World’s Ongoing financial plague with Limited Purpose Banking. Laurence Kotlikoff has revived Fisher’s 100% Money proposal (which I also reviewed) under the name of Limited Purpose Banking, which is setting the reserve ratio at 100%. The idea is that you have only two types of banks. Cash mutual funds hold your cash and give you access to money as a means of payment, while all other mutual funds take your money and invest it in one asset class only. Therefore, if a financial institution goes down, it does so with out side effects. Financial plague solved. Or so Kotlikoff claims.

Since chapters 1 to 5 are just revisiting the financial crisis, putting most blame on fractional reserve banking. Chapter 5 to 7 is where the (100%) money is. Sadly, the book is full of flaws. Let me name just a few, which nevertheless are really important:

1) On p.55 there is Robinson Crusoe on an island. Kotlikoff wants to explain leveraging, but for some reason he ignores the rest of the world. In the real world, net capital inflows to the tune of hundreds of billions of dollars per year made capital in the US abundant. On p. 90, Kotlikoff acknowledges this.

2) Kotlikoff’s knowledge of macroeconomics seems to be dating back to the 1970s and early 1980s. On p. 133 he says “I’m neither a Keynesian nor a Monetarist economist“. It’s a bit like saying: “I’m neither a Whig nor a Democratic-Republican, I am a free mind“. So, in macroeconomics you are mainstream, if you like the New-Neoclassical Synthesis, or you are out of the mainstream. That could mean Austrian, Wicksellian, Minsky-ite, and so on. Paul Krugman, by the way, is not a Keynesian. He just thinks that Keynesian economics has something to say which cannot be expressed by Woodford-style models (like the paradox of thrift). That is different from being a Keynesian.

3) On p.144 Kotlikoff explains leverage. Sandy invests a $1,000 in a fund, and 30 other people do so as well. However, Sandy gets to manage the fund and in 50 percent of the time the investments return $31,000 dollar, while in the other 50 percent $62,000 are returned. The other people get a 3.33% whatever happens. My question: is this leverage, or is this one smart person and 30 dumb persons? Why on earth would you be satisfied with 3.33% in a fund that returns on average 50%? If the other investors smarten up, demand and get a 50% interest rate, then in good years Sandy gets $62,000, pays off the others with $45,000 and pockets $17,000. However, in bad years Sandy owes the investors $15,000 which Sandy might not have. She did only put in $1,000, so what about the rest? Ouch. That wasn’t supposed to happen, was it? Leverage in Limited Purpose Banking can make investors go under, just like today. (You can use this example with a 50 percent chance of a 6.66% return and 3.33% return, and investors getting 5% to see that with lower risk Sandy is not under water. It is the risk that causes the trouble!)

3) The transition which is described in chapter 6 is underestimated. On p. 155 Kotlikoff assures us that “for the vast majority of us who are lower or middle class, mutual fund holdings represent virtually all of our financial wealth”. This is a misrepresentation of the way things are. Here is table 6 from Wolff (2007):

So, even if we include pension accounts, the 20%-80% wealthiest Americans hold only 16.2 of their wealth in mutual funds (and pension accounts). Far more important for them is real estate, since their principal residence makes up two thirds of their wealth. Making real estate markets safe would be even more important for ordinary Americans than regulating the financial markets, it seems.

Some more things I find hard to reconcile with Limited Purpose Banking. My first question would be: what would happen in the next downturn? Surely, business cycles will not stop (and Kotlikoff never makes that claim in his book). So what to do? Inflation-targeting is kind of difficult, because the central bank controls only the money supply and not the interest rate. As we know from the Monetarist experiments in the early 1980s, using money supply as an instrument for monetary policy is a non-starter. People can transform cash into non-liquid assets all the time, so even control over money supply must be disputed.

Also, there are foreign countries, some of them bad but most of them trade partners. How will this work out? How will current account deficits be dealt with by the central bank? Will it be willing to let deflation rule when China does what it did the last few years? Will it ease the pain and increase money supply – and if so, might this not lead to inflation if China dumps its holdings and so on and so on. Sadly, stabilizing the financial sector is not the only task a government has. It has to control inflation and also watch over the external situation (which has been neglected, but wrongly so). Kotlikoff fails to treat those areas and it is in this way that he makes his approach look easy and simple when in fact the world is more complicated.

Personally, I like to think about how a 100% money –  or limited purpose banking – system would behave. It helps to get my thoughts straight. What is caused by leverage, what is caused by fractional reserve banking, how do credit default swaps fit into it? Surely higher reserves would have put some slack into the financial system, but then… a 100% reserve ratio? Going all the way, with neither clear ideas nor the right instruments to deal with business cycles and things international, like trade and exchange rate (systems)? No.

Kotlikoff’s book is not provocative because it doesn’t solve the problems I have described above.  It’s just old wine in new bottles.

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