Dec. 7 (Bloomberg) -- In 1965, consumer advocate Ralph Nader wrote “Unsafe at Any Speed,” a scathing indictment of U.S. autos, including General Motors Corp.’s Chevrolet Corvair.
The car, which my dad once owned, wanted to kill you. It ran in two modes -- forward and tailspin, switching without notice. Nader put an end to the Corvair, saving thousands of lives and making clear that some engineering is simply too dangerous.
Ireland’s banking system proved to be just as risky. Lenders borrowed twice the nation’s gross domestic product, and invested in dicey assets. Because of banking’s code of secrecy, known as “proprietary information,” depositors and other creditors didn’t know precisely how their money was being invested. The bankers said: “Trust us. We’re savvy investors. Your money’s safe.”
This wasn’t modern shadow banking. This was traditional shady banking. It left the economy with two running modes -- forward and tailspin.
If everyone believed the mystery assets had value, the banks were solvent, the economy flourished, and the assets had value. If people stop believing, the banks were broke and the economy’s confidence, performance, and assets were crushed.
With such faith-based banking, it’s terribly easy to switch operating modes. Fraud, suspicions of fraud, or suspicions of suspicions of fraud transforms creditors into discreditors, desperate to get their money out before others take what’s left. Economists call these liquidity runs, but they are fraud runs.
Given global interconnectedness, the fraud run in the U.S. spread and turned Ireland’s economic miracle into a nightmare.
Ireland borrowed massively to stop its run -- 70 percent of GDP (including last week’s $90 billion European Union loan), leaving the country with more debt-to-GDP than Greece.
The government saved the banks by bankrupting the country. Ireland is now in EU receivership and taking draconian steps to keep its creditors happy. Meanwhile, unemployment is around 14 percent and output is down about 10 percent -- all thanks to a handful of testosterone-charged bankers who gambled with an entire country’s future and lost.
Bank of England Governor Mervyn King provided a scathing indictment of the world’s banking system Oct. 25, suggesting that it too was unsafe at any speed. Speaking at the Buttonwood Gathering in New York, King cited Iceland and Ireland as exhibit A. His speech was arguably the most important statement by a Bank of England governor in the Bank’s 316-year history.
‘Worst’ Bank System
King didn’t offer up a profit-and-loss statement and crow, like U.S. officials, that his bank profited from the crisis. Instead, he discussed the horrendous loss-and-loss of workers and retirees and pulled no punches in decrying the status quo.
“Of all the ways we have of organizing banking, the worst is the one we have today,” he said.
King also made clear that neither the Dodd-Frank financial regulation law, nor Basel III, nor anything short of radical financial surgery will keep the world safe from a financial meltdown. The intensifying attacks on Ireland, Portugal, Italy, and Spain are indicative of this fact.
Yes, the Federal Reserve and the European Central Bank can print and distribute trillions of dollars and euros, but they can’t get people jobs, produce real goods and services, or make people use a financial system that has lost credibility and, thus, credit ability.
In discussing safe radical reforms to replace our radically dangerous “financial doomsday machine,” King cited my limited purpose banking proposal as eliminating “financial alchemy” (trust-me banking) and advocated its further study.
Like Mutual Funds
He is leaving the U.K.’s Independent Banking Commission to reach its own conclusion. But if you read King’s speech carefully, he finds the other radical solutions lacking in critical ways.
Limited purpose banking forces all financial corporations (those protected by limited liability) to operate strictly as mutual fund companies. Mutual funds are, effectively, small banks with 100 percent capital requirements. They would buy and hold stocks, bonds, mortgages and other securities with customer funds.
Limited purpose banking also establishes a single government regulator -- the Federal Financial Authority -- to oversee the independent and non-conflicted verification, rating, appraisal, custody, and full and real-time disclosure of all securities held by mutual fund companies. And it requires mutual funds to buy and sell securities in an auction market to ensure households and firms get the best price for their paper.
In short, limited purpose banking turns trust-me banking into show-me banking.
Since mutual funds hold no debt, limited purpose banking eliminates the possibility of bank failures, with their terrible economic costs. And the FFA would put an end to most financial fraud. Rating companies would work for the agency, not security owners.
Regulators, performing the FFA’s limited tasks, would have no way to help future employers. Bribing politicians to do Wall Street’s bidding would be a thing of the past. And boards of directors and chief executives could no longer steal from shareholders; they would be compensated solely on the basis of their mutual fund’s FFA-documented performance.
In the words of George Shultz, former U.S. Treasury Secretary and Secretary of State, limited purpose banking delivers “what the country needs” -- a new financial system that is “simple, clear, and most of all effective.” It would also remove the financial sword of Damocles hanging over Ireland and so many other countries.
The Irish should get up their Irish and end trust-me/mystery-asset banking once and for all. Limited purpose banking is Ireland’s and the world’s best hope for restoring prosperity.
(Laurence Kotlikoff is professor of economics at Boston University, president of Economic Security Planning, Inc. and author of “Jimmy Stewart Is Dead.” The opinions expressed are his own.)
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