How Larry Kotlikoff Would Fix the Financial System

The publishing world is too slow for Laurence J. Kotlikoff. On a frigid January day, the 58-year-old Boston University economist is pecking away at his computer keyboard in his airy office overlooking the Charles River. Kotlikoff's forthcoming book, Jimmy Stewart is Dead, calls for a radical—and swift—reorganization of the financial system. So rather than wait for the book's Feb. 22 publication date, Kotlikoff is e-mailing PDF versions to dozens of economists, journalists, and policymakers. "We have miscreants running the financial system left, right, and center," says Kotlikoff. "Nobody is calling the [Obama] Administration to task and saying, 'You guys are putting a Band-Aid on cancer.'"

Kotlikoff would drain the risk-taking out of commercial and investment banks, hedge funds, and insurance companies—turning them into boring, narrow intermediaries akin to mutual-fund firms. Instead of taking deposits and making loans, banks would connect borrowers and depositors with ultrasafe mutual funds created for those purposes. That would solve the problem of banks not keeping enough money in their vaults to pay depositors if they all wanted their money at once, a flaw vividly demonstrated to George Bailey, the character played by Jimmy Stewart in It's a Wonderful Life (hence the title of Kotlikoff's book).

Kotlikoff sounds so unrealistic that, like George Bailey, he could use a guardian angel to set him straight. But he's beginning to catch the attention of powerful policymakers and the economists who have their ears. In Kotlikoff's biggest coup yet, Bank of England Governor Mervyn King—Britain's counterpart to Federal Reserve Chairman Ben Bernanke—urged members of Parliament to study the plan. In the U.S., Kotlikoff's "limited-purpose banking" idea is finding support among economists across the political spectrum, including University of Chicago Nobel laureate Robert Lucas on the right and Columbia University's Jeffrey Sachs on the left.

People who know Kotlikoff no longer marvel at his zeal. "Being Larry's friend is not for sissies," says Perry Mehrling, an economist at Columbia's Barnard College, borrowing a line famously used about the hyperkinetic economist and Nobel winner Franco Modigliani. Kotlikoff attributes his drive to what he calls a healthy inferiority complex. "I never thought I was the smartest guy in the world," he says.


Kotlikoff grew up with a twin brother and older sister in Pennsauken, N.J., near Philadelphia. Starting at age eight, he helped wrap packages during the Christmas rush at Kotlikoff's, the family-owned department store in Camden. He credits a high school teacher for rescuing him from the "dummies track" in math with a summer of free private tutoring. The extra work helped him get into the University of Pennsylvania, from which he graduated with a degree in economics in 1973. Next came Harvard, where he earned a PhD in 1977. After brief teaching stints at UCLA and Yale and a job in the Reagan White House, he landed at Boston University in 1984 and hasn't moved since, twice serving as department chairman.

Kotlikoff is not shy with his opinions. In The Coming Generational Storm, published in 2004, he and Dallas Morning News columnist Scott Burns advocated turning Social Security into personal retirement accounts. He backs replacing the federal income tax with a national sales tax. He served as economic adviser to the 2008 Presidential campaign of antiwar candidate Mike Gravel, who switched from the Democratic Party to the Libertarian Party in mid-campaign. And in his spare time? He runs a personal-finance software company called ESPlanner that helps people model retirement-saving strategies.

Jimmy Stewart Is Dead is something of an intellectual leap for Kotlikoff because his expertise is in public finance, not banking. He says he thought of writing the book when he saw an estimate that the historic bailout of the financial system, including various credit guarantees, had exposed taxpayers to potential losses approaching the unfunded liabilities of the Social Security system. "The problem," he writes in his book, "is the leveraging of the taxpayer by people with no formal training in finance or economics, no personal downside, an assortment of Napoleonic complexes, the money to buy ratings in New York and policy in Washington, and the ability to run circles around regulators."

Kotlikoff dove into the minutiae of banking, picking the brains of experts and bouncing ideas off them as he went, from conservatives such as Michael Boskin of the Hoover Institution and Kevin Hassett of the American Enterprise Institute to such liberals as Robert Reich of the University of California at Berkeley and Simon Johnson of Massachusetts Institute of Technology, all of whom provided blurbs for his book. "A lot of us got into this to save the world, and we're still trying to save the world," says Kotlikoff. "It's more important than ever."

In Kotlikoff's scenario, banks would be shorn of their risk-taking functions. A deposit would be pooled with other deposits in a new kind of mutual fund, equivalent to a stock mutual fund but with all the money held in plain old cash so there's no chance of not getting it back (though it could still lose value to inflation). That eliminates any reason for a panicky bank run. Mutual funds would supply loans, too. Already, companies raise money by issuing bonds, which are bought by fixed- income mutual funds on behalf of investors. Kotlikoff says loans could work the same way: Mutual funds would pool investors' money and use it to make loans to vetted borrowers. That would cut banks out of the picture, except as go-betweens. The advantage is that if certain borrowers didn't repay, there would be no systemic, global-economy-threatening crisis, like the ones that can occur when one bank goes down and drags others with it. Instead, the worst that could happen is that investors who funded a particular loan would lose part or all of their investment. Insurers couldn't go bust, either, because they would no longer be on the hook for paying claims. People who wanted insurance would simply pool their money for a certain period, and those with verified claims would divvy up whatever was in the pot at the period's end.

One side benefit: Kotlikoff says 100-plus regulatory agencies could be disbanded because financial firms would no longer have other people's money to play with. They would be replaced with a single Federal Financial Authority whose main job would be to verify data supplied by would-be borrowers, such as income statements and the value of collateral.

Some financial economists worry that Kotlikoff would throw out the good of banking along with the bad. "We did not have airplane crashes when people used horses for transportation, but going back to using horses is not the solution to eliminate airplane crashes," says René Stulz of Ohio State University's Fisher College of Business. Anil Kashyap of the University of Chicago Booth School of Business says there's a synergy in banks between taking deposits and making loans. "To chop up the bank and presume that you can do so without destroying some value is a doubtful theoretical proposition," says Kashyap.

Bank lobbyists, meanwhile, don't even want to entertain the idea. The American Bankers Assn. declined multiple requests for interviews on the Kotlikoff plan. No member of Congress has taken up limited-purpose banking as a personal crusade.

Still, seemingly impossible schemes have become reality before. MIT's Johnson likens now to around 1900, when the smart money said John D. Rockefeller's immense Standard Oil trust was impregnable. Then came trust-busting President Theodore Roosevelt and muckraking journalist Ida Tarbell. By 1911 the Supreme Court had broken Standard Oil into 34 companies. Predicts Johnson, who has his own book on financial reform coming out soon: "The same thing is going to happen with regard to massive, too-big-to-fail banks."

Few others are willing to go that far. But Kotlikoff senses he's gaining momentum. Looking across the frozen Charles, where Harvard and MIT loom large, he allows himself to dream. "It's a big kick to see that we can compete with these guys in something. Maybe it's financial reform."

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Sudden Fame in Britain

The British press had a field day after Bank of England Governor Mervyn King cited Laurence Kotlikoff three times in a speech in Parliament on Jan. 26. The Times of London wrote that members of Parliament "were left scratching their heads over the identity of a little-known American economist who, it appears, has been bending the Governor's ear." King didn't endorse Kotlikoff's plan but said it merited "debate and discussion."

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